Financial System

06 January 2024 08:58

• A financial system should be distinguished from payment system.

• A payment system is the institutional arrangement through which purchasing power is transferred
from one transactor in exchange to another.
• The financial system is much broader than a payment system. It is a set of institutional
arrangement through which financial surpluses in the economy are mobilized from surplus units and
transferred to the deficit spenders.
• The institutional arrangement include all conditions and mechanism governing the production,
distribution, exchange and holding of financial assets or instruments of all kinds and the
organization, as well as the manner of operation of financial markets and institutions of all
descriptions.
In concrete terms, financial assets, financial market and financial institutions are the three main
constituents of any financial system.
(Financial System: Creates a bridge between the surplus and the deficit spenders.)

Functions of Financial System

The main objectives of Financial System are to establish a bridge between savers (surplus) and
investors(deficit spenders) and thereby encourage savings and investment, provide finance in
anticipation of saving, enlarge markets over space and time, and allocate financial resources
efficiently for socially desirable and productive purposes. The ultimate goal is to accelerate the
rate of economic development.
The functions performed by a financial system can be broadly classified under the following heads:
• The Saving Function:
• The Liquidity Function:
• The Payment Function:
• The Credit Function:
• The Risk Function:
• The Policy Function: passes certain rules and regulation, presence of certain regulators.

Saving Function:
A financial system streamlines the flow of funds from areas of surplus to the areas of shortage
and deficit. Public savings find their way into the hands of those in production through the financial
system. Financial claims are issued in the money and capital markets, which promise future income
flows. The funds in the hands of the producers result in the production of better goods and
services increasing the living standards of the society.
(To collect the saving, cuz saving gives us capital and in a country like India, we need capital. We have resources, but no capital to
utilize those resources. So we call outside the country to invest in the country. Money market where exchange (give and take) of
money takes within 1 year(short term dealing),
if exchange happens for more than 1 year it is called capital market (long term dealing of the funds). Eg. Loan from IMF to India for
50years.)

Liquidity Function:
(Time required to convert an asset to money. How the people can easily convert the asset to liquid as soon as possible.)

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 Payment Function:
(To pay; from one person to another. If the payment function is more and more swift, the economic activity will work faster.
Eg if someone says he will pay after 15days, the person won't be interested in selling; the production function will suffer. All the
economic activity will work in a faster way, as a result more and more production is happening and the vice versa.
The role is the payment function is to payment the economic activity easy, and fast. More and more economic activity will take
place.)
Financial system tries to bring the payment function to all the sectors of the economy.

Credit Function:
It states that all the individuals have different credit requirements. In the country someone need a TV, he can purchase it in credit.
It needs to be tailor made according to different requirements of the individuals. Saving and consumption both are required, to keep
running the country. The role of credit function is to make the credit available to all the individuals of different types. Eg if
someone asks for credit, and the person receives the credit just after 1hr, the money can be used in less time, therefore increasing
the production.
Risk Function:
To reduce the risk through different means, by making more competitiveness,, more production,
Policy Function:
In order to work all the functions, there is a requirements of policy, because of the presence of the dynamic environment, there is
always uncertainty.; indispensable, to minimize risk, as a result the policies are formed.

Borrowers Preference for FIs

Borrowers also have a preference for FIs due to the following reasons:
1. FIs have big pool of funds so that big individual demands for funds can be satisfied only by the Fis.
2. There is much greater certainty of the availability of funds with the FIs at all times.
3. The rate of interest charged by the Fis is generally lower than that charged by other lenders.
4. Regulated FIs do not fleece small borrowers in the manner moneylenders do. On the contrary, as a
matter of official policy banks and other official lending agencies are required to give small
borrowers preferential treatment both in the grant of credit and in the rate of interest charged
by them. The actual implementation of policy leaves much to be desired.
Borrowers have a belief that the financial institutions have a large pool of money, big amount of funds, provided you are eligible for the
credit. Borrowers approach the financial institutions instead of other private lenders to avail credit.
They are 24*7 available, to provide credit as per the requirements.
Low rate of interest

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14banks were nationalized, why??
India govt. independence, to give the banking services to all the people of the country by creating
branches, to reach more and more number of people.
5banks were nationalized again in 1982, NABARD was also created, gives services to the rural areas to
grow.
SBI + 7 associates.
27natoinalized banks.
1990 new economic policy was introduced.
LPG: Liberalization, Privatization and Globalization
Govt was unable to control all the sectors, so the economic policy came into existence, Banking area
was also reformation was taken into consideration, Private banks were established, foreign banks too.
NPA: Non-performing assets
Home loan, when unable to recovered.
Merge and Acquisition happened.
RRBs concept came in 1995. Eg. Assam Gramin Bikash Bank

Features of Financial Markets:

A financial market is as vital to the economy as blood is to the body.

Features:
• Acts as a Link: Financial Markets connect the investors to the borrowers and bridge the gap
between the two for mutual benefits.
• Easy Accessibility: These markets are readily available anytime for both the investors and the
borrowers.
• Trades in Marketable and Non-Marketable Securities: Financial markets initiate buying and selling of
marketable commodities. Some of these are bonds, debentures, and shares along with non-
marketable securities like bank deposits, post office deposits and other loans and advances.
•
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• Government rules and regulations: The government controls the operations of a financial market in
the country by imposing different rules and regulations.
• Involves Financial Intermediaries: These markets require financial intermediaries such as a bank,
non-banking financial companies, stock exchanges, mutual fund companies, insurance companies,
brokers, etc. to function.
• Deals in Long and Short Term investment: For the investors, financial markets provide an
opportunity of putting in their funds into various securities or schemes for short or long term
investing benefits.

Functions of Financial Markets

• Facilitate Price determination and discovery:
The demand and supply of the various securities in the financial markets regulate their price.
• Mobilize savings:
The financial markets initiate the proper utilization of individual savings to generate profit by
investing it in the right place.
• Accelerate economics development:
when savings are put into use for setting up new businesses and generating revenue, the economy
of the country grows parallel.
• Provide liquidity to financial assets:
the financial market facilitates the quick conversion of securities or commodities into cash as and
when required by the investor.
• Reduce Transaction Cost:
Since the information of the financial instruments or assets is available free of cost on the
financial markets, it lowers the cost of acquisition and selling of the securities.
• Capital Formation:
Raising capital from idle savings for the growth of business, infrastructure and economy is termed
as a capital formation which is an essential function of financial markets.
• Create New Assets and Liabilities:
Financial markets also encourage the creation of new assets in the form of investments and
liabilities through borrowings.
• Determine Capital Formation Rate:
As we know that capital formation is one of the functions of financial markets. The demand and
supply of securities determine their capital formation rate to encourage people to enter the
market.

Any market which deals in financial assets is a financial market. The following are the different
types of financial market:

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 Types of Financial Markets:
• Cash or Spot Market: It is a spot or real-time market where all the trading and transactions are
executed or take place immediately.
• Forward or Futures Market: Unlike cash market, in future and forward markets, the execution of
the transaction takes place on a future date. Here, the price of securities or transaction value is
decided at present to minimize the loss to either party.
• Money Market: The financial market which provides very short-term loans or advances having a
maturity period within a year of issue is termed as a money market.
• Capital Market: This market exists for the trading of medium and long-term financial instruments
between the individuals and financial institutions.
• Primary Market: In a financial market, when the listed companies issue new securities, or new
companies take entry with new stocks, it is called as a primary market.
• Secondary Market:
It is commonly known as the stock market. It is a financial market where the individuals, brokers,
companies, banks and various other parties are involved in trading of existing (already issued
previously) securities.
• Debt Market:
The financial market which facilitates the trading of debt instruments or instrument with fixed
interest such as bonds, fixed deposits, debentures are called debt market.
• Equity Market:
This market deals in financial instruments or securities whose value keeps on fluctuating and the
claimant receives the amount of which persists on the date of redemption.
• Exchange-Traded Market:
The market where trading of call,, put and futures options take place on an organized futures
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 The market where trading of call,, put and futures options take place on an organized futures
exchange in a systematic manner is called an exchange-traded market.
• Over-The-Counter Market:
Unlike an exchange, in this unregulated market, trading of various securities such as exotic options
and derivatives, swaps, credit derivatives, forward contacts take place directly between the two
parties without any involvement of the intermediaries.

The list of money market instruments traded in the money market are:
• Certificate of Deposit
Lending substantial financial resources to an organization can be done against a certificate of
deposit. The operating procedure is similar to that of a fixed deposit, except the higher
negotiating capacity, as well as lower liquidity of the former.
• Commercial Paper
This type of money market instrument serves as a promissory note generated by a
company to raise short term funds. It is unsecured, and thereby can only be used by large-
cap companies with renowned market reputation. The maturity period of these debt
instruments lies anywhere between 7days to one year, and thus, attracts a lower interest
rate than equivalent securities sold in the capital market.
• Treasury Bills
These are only issued by the central government of a country when it requires funds to
meet its short term obligations. These securities do not generate interest but allow an
investor to make capital gains as it is sold at a discounted rate while the entire face value is
paid at the time of maturity. Treasury bills are an optimal investment tool for novice
investors looking for options having minimal risk associated with it. Since treasury bills are
backed by the government, the default risk is negligible, thus serving as an optimal
investment tool for risk-averse investors.
• Repurchase Agreements
Commonly known as Repo, is a short term borrowing tool where the issuer availing the
funds guarantees to repay (repurchase) it in the future. Repurchase agreements generally
involve the trading of government securities. They are subject to market interest rates and
are backed by the government.
• Banker's Acceptance
One of the most common money market instruments traded in the financial sector, a
banker's acceptance signifies a loan extended to the stipulated bank, with a signed
guarantee of repayment in the future.
• Call/Notice Money
It is a segment of the market where scheduled commercial banks lend or borrow on short
notice (say a period of 14 days). In order to manage day-to-day cash flows.
• Inter-Bank Term Market
This market was initially only for commercial and co-operative banks but are now available
-
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 to various financial institutions as well. The interest rates are market-driven. Also the
market is predominantly a 90-day market.

Since money market instruments are traded wholesale over the counter. The government generally
tries to enhance the money circulation in the country to minimize market fluctuations. Thus,
government-backed instruments offer higher returns in these circumstances to boost the demand
for the same.

Capital Market : Need

The capital market is a place where companies raise funds to meet their need for investments,
expansion, long term working capital, repayment of loans and for various other purposes. The
capital market in general also referred to as securities market. It mobilizes the long term savings
of individuals for investment in shares, debentures, units of mutual funds and other financial
instruments.
Here the issuer issues the securities to raise funds for investment and the purchaser of these
claims/instruments has an option to hold a variety of financial assets for his investment, which
yield periodical income or have a pre-determined maturity value. These markets also provide the
investor an option to sell or purchase securities to adjust his holdings in response to changes in
their assessment of risk and to convert his claims into liquidity at any time. The securities market
creates new avenues for an investor to invest his savings.

The capital market deals with the long-term sources of funds whose maturity period is over and
above one year. Capital markets serve as a medium to bring together entrepreneurs initiating
activity involving huge financial resources and surplus units, either individuals institutions seeking
outlets for investment.
On the basis of issuer, capital markets are classified as capital market for govt. securities and
capital market for corporate securities. On the basis of the type of securities, capital markets are
classified into debt and equity markets. Similarly, capital markets are broadly split up into two
types of markets namely, primary markets, i.e. the new issue markets and secondary markets, i.e.
stock markets.
The different types of instruments that are issued in the capital market are :-
Equity shares
Preference shares
Debentures

Primary Market
The primary market is a market for new issues. i,e market for fresh capital. It provides a sale of
new securities. The primary market provides an opportunity to issuers of securities like a govt and
corporations to raise resources to meet requirements of investment or discharge some obligations.
The corporate entities mainly issue debt and equity instruments (shares and debentures) while the
govt issue debt securities (treasury bills). The issues might be released at face value or at a
discount/premium. However these issues can be released in both domestic or international markets.
The primary market issuance is either done through public issues or private placement. When an
issuance of securities is make to new investors for becoming part of shareholders family, it is
called a public issue. When an issuer makes an issue of securities to a specific group of persons
where the no. of members should not be more than 49, it is called private placement.

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Introduction to stock exchange in India
In India, the first organized stock exchange was Bombay stock exchange. It was started in 1877.
Later on, the Ahmedabad stock exchange and Calcutta stock exchange was structured in 1894 and
1908 respectively. At present there are 24 stock exchanges in India. In Europe, stock exchanges are
often called bourses.
It is an organized market for the purchase and sale of securities of joint stock companies, govt and
semi-govt bodies. It is the center, where shares, debentures and govt. securities are bought and
sold.
According to Pyle, "security exchanges are market places where securities that have been listed
thereon may be bought and sold for either investment or speculation." The securities contract
(Regulation) Act 1956, defines a stock exchange as "an association, organization or body of
individuals whether incorporated or not, established for the purpose of assisting, regulating and
controlling of business in buying, selling and dealing in securities."
In short, stock exchange is a place or market where the listed securities are bought and sold.

Characteristics of a stock exchange:

• It is an organized capital market.
• It may be incorporated or non-incorporated body (association or body of individuals).
• It is an open market for the purchase and sale of securities.
• Only listed securities can be dealt on a stock exchange.
• It works under established rules and regulations.
• The securities are bought and sold either for investment or for speculative purpose.

It is also known as aftermarket, as it is the follow in of public offering in the market. It is the
place where stocks, bonds, and futures, issued previously, are bought and sold.
Simply put, it is a market place where securities issues earlier are sold and purchased. The
secondary market facilitates the liquidity and marketability of securities. Secondary market
definition itself states that it is second-hand market, where previously issues securities are bought
and sold.

Key Differences between Primary market/Secondary Market

• The securities are initially issued in a market known as primary market, which is then listed on a
recognized stock exchange for trading, which is known as a secondary market.
• The prices in the primary market are fixed whereas the prices vary in the secondary market
depending upon the demand and supply of the traded securities.
• In the Primary market, the investor can purchase shares directly from the company. In the
secondary market investors buy and sell the stocks and bonds among themselves.
• In the primary market, security can be sold only once, whereas in the secondary market it can be
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• In the primary market, security can be sold only once, whereas in the secondary market it can be
done in infinite no. of times.
• In the primary market the amount received from the securities are the income of the company,
but in the secondary market, it is the income of investors.
• The primary market is rooted in a specific place and has no geographical presence as it has no
organizational setup. Conversely, the secondary market is present physically, as a stock exchange,
which is situated in a particular geographical area.
• Investment bankers do securities trading in case of primary market. Conversely, brokers act as
intermediaries while trading in the secondary market.

Commercial Banks
Commercial banks provide loans and advances of various forms, including an overdraft facility, cash
credit, bill discounting, money at call etc. They also give demand and term loans to all types of client
against proper security. They also act as trustees for wills of their customers etc.
• Commercial banks are a part of an organized money market. They perform all the activities of
typical bank.
• Commercial banks collect, mobile savings from urban and rural areas and make it available to
large, medium and small undertakings for their capital requirements.

Structure of commercial banks

Scheduled & Non-Scheduled Banks
1) State Bank of India
2) Associate Banks
3) Nationalised Banks
4) Private Banks
5) Foreign Banks
6) Regional Rural Banks
7) Cooperative Banks
Scheduled Banks
• The state Bank of India constituted under the State Bank of India Act 1955.
• A subsidiary bank as defined in the state bank of India (subsidiary banks) Act 1959.
• A corresponding new bank constituted under section 3 of the banking companies Acquisition &
transfer of undertaking Act 1970 or under section 3 of the banking companies (Acquisition and
transfer of undertaking) Act, 1980 or any other bank being a bank included in the second
schedule to the reserve bank of India Act 1934, but doesn't include a cooperative bank.
Classification
a. Public Sector Banks:
It referes to commercial banks which are owned by the central govt. directly or through
the Reserve Bank of India. They are also called as National Banks.
They are established by special acts passed by the parliament. Public Sector Bnaks are
further classified into 2 categories.
b. Private Sector Banks:
Private sector Banks refers to commercial banks other than public sector commercial banks
i.e. they are owned and controlled by private entrepreneurs.
Private Sector Banks comprise two categories:
i. Private Sector Indian Banks: It refers to commercial banks owned and controlled by
Indian entrepreneurs. These include UTI Bank, ICICI, HDFC Bank LTD., Bank of Punjab Ltd.
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 Indian entrepreneurs. These include UTI Bank, ICICI, HDFC Bank LTD., Bank of Punjab Ltd.
ii. Foreign Banks: A foreign bank is a bank that was established in a country but serving
customers of another country.
Foreign Banks are bound by all the rules and regulations that are applicable to banks
based out of India and they are governed by the RBI.
Eg. HSBC, CITI Bank, Standard Chartered Bank Ltd.

Indigenous Banker
According to Indian Central Banking enquiry committee, Indigenous banker is any individual or
private firm receiving deposits and dealing in lending money.
Functions of Indigenous Bank
1) Accepting Deposits:
The indigenous bankers accept deposits from the public, these deposits are of 2 types.
i. The deposits which are repayable on demand.
ii. The deposits which are repayable after a fixed period. The indigenous bankers pay
higher rate of interest than that paid by the commercial banks.
2) Advancing Loans:
The indigenous bankers advance loans to their customers against all types of securities such
as land, crops, gold, silver etc. they also give credit against personal security.
i. They provide loans to small industrialist who cannot fulfill the necessary loan conditions
of commercial banks.
ii. Business in Hundis: The indigenous bakers deal in hundis. They write hundis, buy and sell
hundis. They also discount hundis and thereby meet the financial needs of the internal
traders.
iii. They also transfer funds from one place to another through discounting of hundis.
3) Non-banking Functions:
Most of the indigenous bankers also carry on their non-banking business along with the
banking activities.
i. They generally have their retail trading business.
ii. Sometimes, they act as agents to large commercial firms and earn income in the form
of commission.
iii. They also participate in speculative activities.

Role of Commercial Banks in India

• Trade Development: The commercial banks provide capital, technical assistance and other
facilities to business men according to their need, which leads to development in trade.
• Supports to Agricultural development
• Supports to Industrial Development
• Capital Formation: Capital Formation means increase in number of production units, technology,
plant and machinery.

Development of Foreign Trade:

Letter of credit is issued by the importers bank to the exporters to ensure the payment.. The
banks also arrange foreign exchange.
• Transfer of Money
• Supports to more Production (agriculture and industry)
• Development of transport (banks financed the transport sector)
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• Development of transport (banks financed the transport sector)

Accelerating the Rate of Capital Formation:

They encourage the habit of savings amongst people and mobilize idle resources for production
purpose.

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