FAC241 - BANKING, Winter 2022

SESSION 2 - FINANCIAL SYSTEM

Learning Objectives LO1 – The structure of financial system

LO2 – The structure of the Indian Financial System

BACKGROUND
On any given day, we all go about our daily routines and undertake multiple activities whether we are
studying in a college or working in a corporate house. Even if these activities are not directly responsible
for any income generation, they are definitely linked to some financial aspect of the economy. Behind
the scenes there are a multitude of actions that are set in motion every time we transact. Whether it the
fees that we pay for tuition, or use the public transport system, or even the food that we buy and
consume on a daily basis, it is all enabled by the smooth functioning of the economy. This economy is
kept running and growing by a financial mechanism that runs in the background. Beneath the surface
however, the financial transactions are quite complicated.
All this tells us that there is a complex web of interdependent institutions and markets that is the
foundation for our daily financial transactions. The system is so efficient that most of us rarely take note
of it. But a financial system is like air to an economy: If it disappeared suddenly, everything would grind
to a halt.
So, what happens in the financial system—whether for good or for bad—matters greatly for all of us. To
understand the system—both its strengths and its vulnerabilities—let’s take a closer look.

SYSTEM
A set of complex, closely connected / interlinked institutions, agents, practices, markets, transactions,
claims and liabilities in the economy.

FINANCIAL SYSTEM
Financial system is concerned with Money, Credit and Finance.
● MONEY – medium of exchange or means of payment
● CREDIT / LOAN – sum of money to be returned, normally with interest – Debt
● FINANCE – monetary resources comprising of debt and ownership funds of the state, company or
person
FUNCTIONS OF FINANCIAL SYSTEM
Collection of Savings
● One of the important functions is to link the savers (those who have surplus income – income >
consumption requirements) and demanders (who are need of funds) / investors (who invest
money raised in various productive activities i.e., business, industry etc.) (those whose needs are
more than the available resources – fund requirements > the available funds) and, thereby help
in mobilizing and allocating the savings efficiently and effectively.

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● The financial system facilitates collection of surplus to be utilized by those who want to use these
resources more productively. By acting as an efficient conduit for allocation of resources, it
permits continuous upgradation of technologies for promoting growth on a sustained basis.
Distribution of Industrial Investments
● Investment obviously requires that there is corresponding amount of saving. Those who have the
capacity and willingness to save, but not to undertake production, may only save and entrust their
savings to others either directly or indirectly through financial intermediaries. These other
persons may have both the competence and willingness to organize production, but may not have
enough resources of their own to make the required investments. The financial system makes it
possible for them to make use of their entrepreneurial skills by providing them credit. Apart from
encourag-ing investment, this makes possible the better use of scarce entrepreneurial and
technical skills in the country.
● Financial system also makes sure that one can liquidate his or her savings whenever he or she
wants it and therefore individuals can have both the things, which involve return on investments
as well as comfort that they can liquidate their investments whenever they want.
Simulating capital formation
● Finance is the blood for any commercial as well as non-commercial activities. These are made
available through banks, households and different financial institutions. They mobilize savings and
put them to productive uses which leads to Capital Formation.
Accelerating the process of economic development
● The continuous capital formation though productive use of financial resources leads to increased
employment opportunities, increased production, growth of agriculture and service sector. It also
supports entrepreneurial spirit and risk taking abilities of business. These collectively leads to
economic development.

COMPONENTS OF THE FINANCIAL SYSTEM

The financial system has six parts, each of which plays a fundamental role in the economy. Those parts
are financial asset, financial instruments, financial markets, financial institutions, government regulatory
agencies, and central banks.
1. Financial asset, represents a claim on someone else for a payment.
2. We use the second part, financial instruments, to transfer resources from savers to investors and
to transfer risk to those who are best equipped to bear it. Stocks, mortgages, and insurance
policies are examples of financial instruments.
3. The third part of our financial system, financial markets, allows us to buy and sell financial
instruments quickly and cheaply. The National Stock Exchange (NSE) is an example of a financial
market.
4. Financial intermediaries, the fourth part of the financial system, who facilitate fund transfer from
suppliers to demanders as well as provide a variety of services, including access to the financial
markets and collection of information about prospective borrowers to ensure they are
creditworthy. Banks, securities firms, and insurance companies are examples of financial
intermediaries.

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5. Government regulatory agencies form the fifth part of the financial system. They are responsible
for making sure that the elements of the financial system—including its instruments, markets,
and institutions— operate in a safe and reliable manner. Central banks, are the key regulatory
agency to monitor and stabilize the economy. The Federal Reserve System is the central bank of
the United States whereas the Reserve Bank of India is the central bank in India.

THE FINANCIAL SYSTEM

Financial Asset
Money
While the essential functions that define these six categories endure, their form is constantly evolving.
Money once consisted of gold and silver coins. These were eventually replaced by paper currency,
which today is being eclipsed by electronic funds transfers. Methods of accessing means of payment
have changed dramatically as well. Till very recently, people customarily obtained currency from bank
tellers when they cashed their cheques or withdrew their savings from the local bank using withdrawal
slips. Today, they can get cash from practically any ATM anywhere in the world. To pay their bills,
people once wrote cheques and mailed them, then waited for their monthly bank statements to make
sure the transactions had been processed correctly. Today, payments can be made automatically, and
account holders can check the transactions at any time on their bank’s website or on their
smartphone.

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Financial Instruments
 Financial instruments is a broader term used for those which are tradable as well as non-tradable. A
financial instrument with marketability (tradable) is known as a security- has evolved just as much as
currency. In the last few centuries, investors could buy individual stocks through stockbrokers, but the
transactions were costly. Furthermore, putting together a portfolio of even a small number of stocks
and bonds was extremely time consuming; just collecting the information necessary to evaluate a
potential investment was a daunting task. As a result, investing was an activity reserved for the
wealthy. Today, financial institutions offer people with as little as Rs. 500 to invest by purchasing
shares in mutual funds, which pool the savings of a large number of investors. Because of their size,
mutual funds can construct portfolios of hundreds or even thousands of different stocks and/or
bonds.
 "A financial instrument is the written legal obligation of one party to transfer something of value,
usually money, to another party at some future date, under specified conditions."
 So first, a financial instrument is a written legal obligation that is subject to government enforcement.
That is, a person can be compelled to take the action specified in the agreement. The enforceability
of the obligation is an important feature of a financial instrument. Without enforcement of the
specified terms, financial instruments would not exist.
 Second, a financial instrument obligates one party to transfer something of value, usually money, to
another party. By party, we mean a person, company, or government. Usually the financial instrument
specifies that payments will be made. For example, if you get a car loan, you are obligated to make
monthly payments of a particular amount to the lender. And if you have an accident, your insurance
company is obligated to fix your car, though the cost of the repair is left unspecified.
 Third, a financial instrument specifies that payment will be made at some future date. In some cases,
such as a car loan that requires payments, the dates may be very specific. In others, such as car
insurance, the payment is triggered when something specific happens, like an accident.
 Finally, a financial instrument specifies conditions under which a payment will be made. Some
agreements specify payments only when certain events happen. That is clearly the case with car
insurance and with stocks as well. The holder of a stock owns a small part of a firm and so can expect
to receive occasional dividends. There is no way to know in advance, however, exactly when such
payments will be made. In general, financial instruments specify a number of possible contingencies
under which one party is required to make a payment to another.
 Most common securities are – equity shares / stocks and bonds / debentures
Financial Market
Financial markets are a mechanism enabling participants to deal in financial claims. In financial markets,
funds or savings are transferred from surplus units to deficit units through a market platform.
 Money market and capital market are the common types of financial markets.
 Money Market –
 Market for satisfying short-term requirements of funds.
 Short-term securities (having a maturity of less than a year) are offered and traded
here.

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 It is where financial instruments with high liquidity and very short maturities (as short
as over-night) are offered and traded.
 Among the most common money market instruments are, Treasury bills (T-Bills),
Certificate of Deposit, Commercial Paper, etc.
 Capital Market –
 Market for long term securities i.e. securities having a maturity period of one year or
more.
 Capital market is a market where buyers and sellers engage in trade of financial
securities like bonds, shares, etc.
 The buying/selling is undertaken by participants such as individuals and institutions.
 Capital markets help channelise surplus funds from savers to corporates and
institutions which then invest them into productive use.
 Financial markets can also be classified as Primary market and Secondary market and Derivative
market
 Primary market
 Deals in new issues
 The primary market is also known as new issues market.
 Here, the transaction is conducted between the issuer of the security and the buyer
of the security who actually invests his/her surplus money in the securities offered by
the issuer.
 In short, the primary market creates new securities and offers them to the public.
 It gives access to fresh / additional resources to the issuer.
 For instance, Initial Public Offering (IPO) is an offering of the primary market where a
company decides to sell shares to the public for the first time.
 An important point to remember here is that in the primary market, securities are
directly purchased from the issuer.
 Secondary market
 Meant for trading in outstanding or existing securities.
 Here, the securities first issued in the primary market are bought and sold.
 One can buy / sell shares through a broker who acts as an intermediary between two
parties.
 The trade happens between investors without any involvement with the company
that issued the securities in the primary market.
 Derivatives –
 A derivative is and instrument whose value is derived from some underlying asset/
security - a contract between two or more parties whose value is based on an agreed-
upon underlying financial asset, index, or security.

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 Future contracts, forward contracts, options, swaps and warrants are common
derivatives.
 A futures contract, for example, is a derivative because its value is affected by the
performance of the underlying contract. Similarly, a stock option is a derivative
because its value is "derived" from that of the underlying stock.
The Role of Financial Markets
Financial markets serve three roles in our economic system. They offer savers and borrowers liquidity;
they pool and communicate information; and they allow risk sharing.
Liquidity
We encountered the concept of market liquidity in our discussion of money, where we defined it as
the ease with which an asset can be turned into money without loss of value. Without financial
markets and the institutional structure that supports them, selling the assets we own would be
extremely difficult. Thus, we cannot overstate the importance of liquidity for the smooth operation
of an economy. Just think what would happen if the stock market were open only one day a month.
Stocks would surely become less attractive investments. If you had an emergency and needed
money immediately, you probably would not be able to sell your stocks in time. Liquidity is a crucial
characteristic of financial markets.
Related to liquidity is the fact that financial markets need to be designed in a way that keeps
transactions costs—the cost of buying and selling—low. If you want to buy or sell a stock, you must
pay a licensed professional to complete the purchase or sale on your behalf: A broker can find you
a counterparty, a dealer can act as the counterparty, and a broker-dealer can do either or both.
While this service can’t be free, it is important to keep its cost relatively low. The very high trading
volumes that we see in the stock market— a few lac crores worth of shares traded on BSE & NSE
per day - is evidence that the stock markets have low transactions costs and are usually very liquid.
Information
Financial markets pool and communicate information about the issuers of financial instruments,
summarizing it in the form of a price. Does a company have good prospects for future growth and
profits? If so, its stock price will be high; if not, its stock price will be low. Is a borrower likely to
repay a bond? The more likely repayment is, the higher the price of the bond. Obtaining the answers
to these questions is time consuming and costly. Most of us just don’t have the resources or know-
how to do it. Instead, we turn to the financial markets to summarize the information for us so that
we can find it on a website.
Risk Sharing
Finally, while financial instruments are the means for transferring risk, financial markets are the
place where we can do it. The markets allow us to buy and sell risks, holding the ones we want and
getting rid of the ones we don’t want. A prudent investor holds a collection of assets called a
portfolio , which includes a number of stocks and bonds as well as various forms of money. A well
designed portfolio has a lower overall risk than any individual stock or bond. An investor constructs
it by buying and selling financial instruments in the marketplace. Without the market, we wouldn’t
be able to share risk.

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Financial Intermediaries
Institutions which facilitate transfer of funds from the suppliers (those having surplus funds) to
demanders/ investors (those who are in need of funds). They raise funds (borrow) from the suppliers and
provide / make them available (loans) to the demanders. The institutions which provide credit and credit
related services are called financial intermediaries.
To understand the importance of financial intermediaries, think what the world would be like if they
didn’t exist. Without an intermediary, individuals and households wishing to save would either have to
hold their wealth in cash or figure out some way to funnel it directly to companies or households that
could put it to use. The assets of these household savers would be some combination of government
liabilities and the equity and debt issued by corporations and other households. All finance would be
direct, with borrowers obtaining funds straight from the lenders. Such a system would be unlikely to
work very well, for a number of reasons.
 First, individual transactions between saver-lenders and spender-borrowers would likely be
extremely expensive. Not only would the two sides have difficulty finding each other, but even if
they did, writing the contract to effect the transaction would be very costly.
 Second, lenders need to evaluate the creditworthiness of borrowers and then monitor them to
ensure that they don’t abscond with the funds. Individuals are not specialists in monitoring.
 Third, most borrowers want to borrow for the long term, while lenders favor more liquid short-term
loans. Lenders would surely require compensation for the illiquidity of long-term loans, driving the
price of borrowing up. A financial market could be created in which the loans and other securities
could be resold, but that would create the risk of price fluctuations. All these problems would
restrict the flow of resources through the economy. Healthy financial institutions open up the flow,
directing it to the most productive investments and increasing the system’s efficiency.

Chief characteristics of financial intermediaries are as follows:

1. Savings mobilizers: They act as savings mobilizers.
2. Participants: Financial intermediaries are the major participants in the financial system of a
country.
3. Dealers: Financial intermediaries deal in financial resources, collecting resources by accepting
deposits from individuals and institutions and lending them to trade, industry and others. Also,
they deal in financial assets, accept deposits, grant loans and invest in securities besides rendering
various specialized financial services.
4. Generators: Buy and sell financial instruments
5. Regulation: Regulated by regulatory body (eg. in India - RBI, SEBI etc.)
6. Types: Banking and Non-Banking
7. Special Institutions: Engaged in providing financial assistance for specific purposes and sectors to
bring about a desired pattern of development. (eg. in India - NABARD, EXIM Bank, IDBI etc.)

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Regulatory Agencies
The activities of government regulatory agencies and the design of regulation have been evolving and
have entered a period of more rapid change, too. In the aftermath of multiple financial crisis in various
parts of the world, and ever since independence the Reserve Bank of India (RBI) along with other
governmental regulatory agencies like the SEBI and IRDAI have been entrusted with the task of providing
wide-ranging financial regulation—rules for the operation of financial institutions and markets—and
supervision —oversight through examination and enforcement.
These reforms will take years to implement, and their influence will shape the financial system for
decades.
Central Banks
Finally, central banks have changed and evolved a great deal. In India the central bank function has
basically evolved out of the self-regulatory environment of the erstwhile presidency banks of the
British era. Eventually, these government treasuries grew into the modern central banks we know
today. Nearly every country in the world has a central bank, and they have become one of the most
important institutions in government. Central banks control the availability of money and credit to
promote low inflation, high growth, and the stability of the financial system.

STRUCTURE OF THE INDIAN FINANCIAL SYSTEM

 MONEY
The supply of base money into the local financial system is tightly regulated by the RBI. This supply
of money is further transformed into ‘broad money’ through the process of money multiplication
by the commercial banking system.
Together, this money and credit is used by the financial system to carry out all transactions in the
economy. The regulated supply of money has very far reaching implications for the smooth
functioning of markets and intermediaries of the financial system. In fact it has a direct connection
with the health of the economy.

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India is a mixed economy. The Government intervenes in the financial system to influence macroeconomic
variables like interest rate or inflation. Thus, credits can be made available to corporate at a cheaper rate.
This leads to economic development of the nation.
The financial system in India has undergone tremendous transformation over the years especially as a
part of LPG (liberalization, privatization and globalization) process. The erstwhile market dominated by
government owned and supported entities started facing competition from the private players from India
and abroad. They were made to rethink about their survival through the process of privatization. All these
made the market more competitive leading to benefits to the players in the market place in terms of
variety of products & services, improved quality and strength and all these was available at competitive
prices.
 REGULATORY AGENCIES
 Formal/Organized Financial System
The formal financial system comes under the purview of MoF (Ministry of Finance). Where RBI,
SEBI and IRDA are the key regulatory bodies.
 MoF: The Ministry of Finance is an important ministry within the Government of India
concerned with the economy of India, serving as the Indian Treasury Department. In
particular, it concerns itself with taxation, financial legislation, financial institutions, capital
markets, centre and state finances, and the Union Budget.
 RBI: The Reserve Bank of India (RBI) is India's central banking and monetary authority. RBI
regulates loans offered by banks and non-banking financial institutions to government
entities, businesses, and consumers and controls the availability of funds in the financial
system for credit. Money market also comes under the purview of the RBI.
 SEBI: The Securities and Exchange Board of India (SEBI) is the designated regulatory body for
the finance and investment markets in India. The board plays a vital role in maintaining stable

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and efficient financial and investment markets by creating and enforcing effective regulation
in India's financial market. Capital market comes under the purview of the SEBI.
 IRDA: Insurance Regulatory and Development Authority of India (IRDA) is the regulatory body
that oversees the insurance business in India. It protects the interests of the policyholders,
regulates, promotes and ensures orderly growth of the insurance in India.
 Informal/Unorganized Financial System
Each economy has an existence of a parallel informal system. They play an important role for
those who do not have / are not able to get access of the formal segment of the financial system.
The informal financial system in India largely consist of moneylenders, local bankers, traders,
landlords, pawn brokers etc.
 FINANCIAL INTERMEDIARIES
Together these financial intermediaries control and facilitate the bulk of the transactions that take
place in the system.
Classification of Financial Intermediaries -
 Banking: A bank is a financial institution licensed to mobilise funds through deposits and give out
loans. They facilitate economic activities through the payments systems. They also undertake
lending to individual as well as industry. Banks may also provide financial services, such as wealth
management, currency exchange and safe deposit boxes.
 Non-Banking: includes Developmental/ Public Financial Institutions (DFIs/ PFIs), NBFCs as well as
Housing Finance Companies (HFCs). Non-banking institutions have shown tremendous growth in
the recent past and have in fact overtaken the banks in certain respects. Since these companies
are regulated more leniently compared to the banks, they are able to take more aggressive risks
in the market place and hence grow faster.
 Mutual Funds: A mutual fund is an investment vehicle made up of a pool of funds collected from
many investors for the purpose of investing in securities such as stocks, bonds, money market
instruments and similar assets. They specialise in providing investment services that include
wealth management and financial advisory services. They also provide access to investment
products that may range from stocks and bonds all the way to lesser-known alternative
investments, such as hedge funds and private equity investments.
 Insurance: Providing insurance, whether for individuals or corporations, is one of the oldest
financial services. Protection of assets and protection against financial risk, secured through
insurance products, is an essential service that facilitates individual and corporate investments
that fuel economic growth.
Insurance is a means of protection from financial loss. It is a form of risk management primarily
used to hedge against the risk of a contingent, uncertain loss.
An entity which provides insurance is known as an insurer, insurance company, or insurance
carrier.
Types of insurance:
 Life insurance: Life insurance is a protection against financial loss that would result from the
premature death of an insured.

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 General Insurance: General insurance covers insurance of property against fire, burglary,
theft; personal insurance covering health, travel and accidents; and liability insurance
covering legal liabilities. Most general insurance products are annual contracts.
 FINANCIAL MARKETS
The Money Market in India is well structured and stable in nature. This market deals in short
securities of less than a year, and institutions access this market with a view to manage short term
liquidity, including cash. Since banks have a regulatory obligation to manage their liabilities
through liquid assets, they are the prominent institutions that regularly tap the money market.
The Capital Markets are used by institutions – both Governmental and Corporate – to raise capital
for productive use. The two main avenues for raising capital are Equity markets and Debt markets.
We have a very vibrant and thriving equity market scene in the country. Major exchanges that are
symbolic of these markets like BSE and NSE have shown tremendous growth in the last few
decades. India has the highest number of listed companies in the world. Record high volumes of
trade are regularly recorded on the leading exchanges of the country. The IPO market in the
country is also very robust, with new and existing companies regularly accessing the markets to
raise funds through share sale and placements. This is also supported through other activities like
Private Equity and Venture Capital funding.
The Debt market in the country is relatively underdeveloped. It deals with both government and
corporate debt through bonds, debentures and government securities, but debt seems to lose
out to equity as a preferred source of capital for the Indian investor. Most of this market action is
conducted through designated dealers.
 FINANCIAL INSTRUMENTS
Financial claims such as financial assets and securities dealt in a financial market are
referred to as financial instruments. It is a claim against a person or an institution for
payment, at a future date, of a sum of money and/or a periodic payment in the form of
interest or dividend.
There are variety of financial instruments available in the market catering to different
requirements of the borrowers and investors. They are typically classified (depending on the
maturity/ tenure) as -
 Short term instruments - are generally used to manage cash and liquidity eg. money market
instruments like commercial papers, T-Bills etc.
 Medium term instruments - help in managing funding requirements linked to long-term
working capital / intermediate requirements of the business eg. public deposits, debentures
of shorter maturity
 Long term instruments - help in raising capital to meet with the long term / permanent
requirements of the business eg. equity shares, debentures etc.
There is also a very well developing derivatives market in the country. These derivative
instruments are available for a wide variety of underlying assets like commodities, equity, debt
etc. Nowadays derivative trades far outstrip the volumes of trade in the cash segments on most
exchanges.

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National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) are the well-known and most
traded stock exchanges in India.
 FINANCIAL SERVICES
Financial services are those that help with borrowing and funding, lending and investing, buying and
selling securities, making and enabling payments and settlements, and managing risk exposures in
financial markets.
Financial services are crucial for any financial system that facilitate the user to meet with his/her
financial requirements through various credit instruments, financial products and services.
Few of the widely used financial services include leasing, hire purchase, factoring, portfolio
management, merchant banking, underwriting, credit rating, etc.

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