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INTRODUCTION TO FINANCIAL SYSTEM

Introduction: Economic growth and development of any country depends upon a wellknit financial system. Financial system comprises, a set of sub-systems of financial institutions, financial markets, financial instruments and services which help in the formation of capital. Thus a financial system provides a mechanism by which savings are transformed into investments and it can be said that financial system play an significant role in economic growth of the country by mobilizing surplus funds and utilizing them effectively for productive purpose. The financial system is characterized by the presence of integrated, organized and regulated financial markets, and institutions that meet the short term and long term financial needs of both the household and corporate sector. Both financial markets and financial institutions play an important role in the financial system by rendering various financial services to the community. They operate in close combination with each other.

Financial System of any country consists of financial markets, financial institutions , financial instruments and financial Services.
Flow of funds (savings)
Seekers of funds (Mainly business firms and government) Suppliers of funds (Mainly households)

Flow of financial services Incomes , and financial claims

Financial System

financial system is a network of financial institutions, financial markets, financial instruments and financial services to facilitate the transfer of funds. The system consists of savers, intermediaries, instruments and the ultimate user of funds. The level of economic growth largely depends upon and is facilitated by the state of financial system prevailing in the economy. Efficient financial system and sustainable economic growth are corollary. The financial system mobilises the savings and channelizes them into the productive activity and thus influences the pace of economic development. Broadly speaking, financial system deals with three inter-related and interdependent variables, i.e., money, credit and finance.

Role/ Functions of Financial System The functions of financial system can be enumerated as follows:
The main function of Indian Financial system is collection of saving and their distribution for industrial development , therby stipulating the capital formation and to the extent accelerating the process of economic growth. The process of capital formation comprises of three distinct but interrelated activities: Savings- The effective mobilization of savings Finance-The efficiency of the financial organization Investment-The channelization of these savings into the most desirable productive forms of investment Financial system works as an effective channel for optimum allocation of financial resources in an economy. It helps in establishing a link between the savers and the investors. Financial system allows asset-liability transformation. Banks create claims (liabilities) against themselves when they accept deposits from customers but also create assets when they provide loans to clients.

Economic resources (i.e., funds) are transferred from one

party to another through financial system. The financial system ensures the efficient functioning of the payment mechanism in an economy. All transactions between the buyers and sellers of goods and services are effected smoothly because of financial system. Financial system helps in risk transformation by diversification, as in case of mutual funds. Financial system enhances liquidity of financial claims. Financial system helps price discovery of financial assets resulting from the interaction of buyers and sellers. For example, the prices of securities are determined by demand and supply forces in the capital market.
Financial system helps reducing the cost of transactions.

Component Of Indian Financial System

Financial Institutions Banking Institution s Commerci al Bank NonBanking Institution s

Financial Markets

Financial Instrument

Financial Services Fund Based Services

Money Market

Capital Market Short Term

Term

Fee Base Services

Co-operative Bank

Primary Market

Secondary Market

Derivative Market

FOREX Market

Long Term

Components/ Constituents of Indian Financial system:

The following are the four main components of Indian Financial system

1. Financial institutions 2. Financial Markets 3. Financial Instruments/Assets/Securities 4. Financial Services.

Regulators
The formal financial system comes under the

regulations of the ministry of finance (MOF), reserve Bank of India (RBI), Securities and Exchange board of India (SEBI) and other regulatory bodies.

Formal and Informal Financial System


The financial systems of most developing countries are characterized by co-existence and cooperation between the formal and informal financial sectors. The formal financial sector is characterized by the presence of an organized, institutional and regulated system which caters to the financial needs of the modern spheres of economy. The informal financial sector is an unorganized, non-institutional and non-regulated system dealing with traditional and rural spheres of the economy.
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Financial Institutions

Commercial Banks

NBFCs

Insurance Companies

Mutual Funds

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Financial institutions
Financial institutions are the intermediaries who facilitates smooth functioning of the financial system by making investors and borrowers meet. They mobilize savings of the surplus units and allocate them in productive activities promising a better rate of return. Financial institutions also provide services to entities seeking advises on various issues ranging from restructuring to diversification plans. They provide whole range of services to the entities who want to raise funds from the markets elsewhere. Financial institutions act as financial intermediaries because they act as middlemen between savers and borrowers. These financial institutions may be Banking or Non-Banking institutions.

Types Of Financial Institutions


Commercial Banks NBFCs

Mutual Funds
Insurance Organizations

Commercial Banks
A commercial bank accepts deposits and pools those funds to provide credit, either directly by lending, or indirectly by investing through the capital markets. Within the global financial markets, these institutions connect market participants with capital deficits (borrowers) to market participants with capital surpluses (investors and lenders) by transferring funds from those parties who have surplus funds to invest (financial assets) to those parties who borrow funds to invest in real assets.
According to Prof. Sayers, "A bank is an institution

whose debts are widely accepted in settlement of other people's debts to each other." In this definition Sayers has emphasized the transactions from debts which are raised by a financial institution.

Functions of Commercial Banks

Non Banking Financial Institutions


Non-banking financial companies (NBFCs) are fast emerging as an important segment of Indian financial system. It is an heterogeneous group of institutions (other than commercial and co-operative banks) performing financial intermediation in a variety of ways, like accepting deposits, making loans and advances, leasing, hire purchase, etc. They raise funds from the public, directly or indirectly, and lend them to ultimate spenders. They advance loans to the various wholesale and retail traders, small-scale industries and selfemployed persons. Thus, they have broadened and diversified the range of products and services offered by a financial sector. Gradually, they are being recognized as complementary to the banking sector due to their customeroriented services; simplified procedures; attractive rates of return on deposits; flexibility and timeliness in meeting the credit needs of specified sectors; etc.

The working and operations of NBFCs are regulated by

the Reserve Bank of India (RBI) within the framework of the Reserve Bank of India Act, 1934 (Chapter III B) and the directions issued by it under the Act. As per the RBI Act, a 'non-banking financial company' is defined as:- (i) a financial institution which is a company; (ii) a non banking institution which is a company and which has as its principal business the receiving of deposits, under any scheme or arrangement or in any other manner, or lending in any manner; (iii) such other non-banking institution or class of such institutions, as the bank may, with the previous approval of the Central Government and by notification in the Official Gazette, specify.

The NBFCs accepting public deposits should comply with the Non-Banking Financial Companies Acceptance of Public Deposits ( Reserve Bank) Directions, 1998, as issued by the bank. Some of the important regulations relating to acceptance of deposits by the NBFCs are:They are allowed to accept/renew public deposits for a minimum period of 12 months and maximum period of 60 months. They cannot accept deposits repayable on demand. They cannot offer interest rates higher than the ceiling rate prescribed by RBI from time to time. They cannot offer gifts/incentives or any other additional benefit to the depositors. They should have minimum investment grade credit rating. Their deposits are not insured. The repayment of deposits by NBFCs is not guaranteed by RBI.

Types of NBFCs
Equipment leasing company:- is any financial institution whose principal business is that of leasing equipments or financing of such an activity. Hire-purchase company:- is any financial intermediary whose principal business relates to hire purchase transactions or financing of such transactions. Housing Finance Companies Venture Capital Funds Merchant Banking Organizations Credit Rating Agencies

Stock Broking Firms Etc

Mutual Funds
A Mutual Fund is a trust that pools the savings of a number of

investors who share a common financial goal.


The money thus collected is then invested in capital market

instruments such as shares, debentures and other securities.


The income earned through these investments and the capital

appreciation realised are shared by its unit holders in proportion to the number of units owned by them.
Thus a Mutual Fund is the most suitable investment for the common

man as it offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost.

A Mutual Fund is set up in form of trust which has: Sponsor


Akin to the Promoter of the company, Contribution of minimum 40% of net worth of AMC, Posses sound financial record over five years period, Establishes the Fund, Gets it registered with the SEBI, Forms a trust, & appoints Board of trustee.

Trustees
Holds assets on behalf of unit holders in trust, Trustees are caretaker of unit holders money, Two third of the trustees shall be independent persons

(not associated with the sponsor), Trustees ensure that the system, processes & personnel are in place, Resolves unit holders GRIEVANCES, Appoint AMC & Custodian, & ensure that all activities are accordance with the SEBI regulation.

Asset Management Company


Floats schemes & manages according to SEBI,
Can not undertake any other business activity, other than

portfolio mgmt services, The AMC must have a net worth of at least 10 crore at all times. At least 50% of directors of the AMC are independent directors who are not associated with the Sponsor in any manner Chairman of AMC can not be a trustee of any MF.

Custodian
Holds the funds securities in safekeeping,

Settles securities transaction for the fund,


Collects interest & dividends paid on securities, Records information on corporate actions.

Types Of Mutual Fund Schemes


On the basis of structure On the basis of nature On the basis of Investment Objectives Growth Schemes Other Schemes

Open Ended Schemes

Equity Fund

Tax saving schemes

Close Ended Schemes

Debt Fund

Income Schemes

Index schemes Sector specific schemes

Balanced Fund

Balanced Schemes Money Market Schemes

Insurance Organizations
Insurance in its basic form is defined as A contract

between two parties whereby one party called insurer undertakes in exchange for a fixed sum called premiums, to pay the other party called insured a fixed amount of money on the happening of a certain event." In simple terms it is a contract between the person who buys Insurance and an Insurance company who sold the Policy. By entering into contract the Insurance Company agrees to pay the Policy holder or his family members a predetermined sum of money in case of any unfortunate event for a predetermined fixed sum payable which is in normal term called Insurance Premiums.

Financial Markets
Capital Market
Primary Market Secondary Market
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Money Market

Financial Markets:

Finance is a prerequisite for modern business and financial institutions play a vital role in economic system. It's through financial markets the financial system of an economy works. The main functions of financial markets are:

1. To facilitate creation and allocation of credit and liquidity; 2. To serve as intermediaries for mobilization of savings; 3. To assist process of balanced economic growth; 4. To provide financial convenience.

Types Of Financial Markets


Money Market- for short-term funds (less than a

year)
Organised (Banks)

Unorganised (money lenders, chit funds, etc.)

Capital Market- for long-term funds Stock Market Bond Market

CAPITAL MARKET
Capital market is market for long term securities. It contains financial instruments of maturity period exceeding one year. It involves in long term nature of transactions. It is a growing element of the financial system in the India economy. It differs from the money market in terms of maturity period & liquidity. It is the financial pillar of industrialized economy. The development of a nation depends upon the functions & capabilities of the capital market.

In short
It provide resources needed by medium and large scale

industries. Purpose for these resources Expansion Capacity Expansion Investments Mergers and Acquisitions
Deals in long term instruments and sources of funds

Main Activity
Functioning as an institutional mechanism to

channelize funds from those who save, to those who needed for productive purpose. Provides opportunities to various class of individuals and entities.

Usually the capital markets are classified in two ways: On the basis of issuer the capital market can be classified again two types: Corporate securities market Governments securities market
On the basis of financial instruments the capital markets are

classifieds into two kinds: Equity market: The equity market can be divided into two categories
(a) primary market (b) secondary market

Debt market: Debt market represents the market for long term

financial instruments such as debentures, bonds, etc.

Primary Market

It is that market in which shares, debentures and other securities are sold for the first time for collecting longterm capital. This market is concerned with new issues. Therefore, the primary market is also called New issue market. In this market, the flow of funds is from savers to borrowers (industries), hence, it helps directly in the capital formation of the country. The money collected from this market is generally used by the companies to modernize the plant, machinery and buildings, for extending business, and for setting up new business unit.

Features of Primary Market


It Is Related With New Issues It Has No Particular Place It Has Various Methods Of Float Capital: Following are the methods of raising capital in the primary market: i) Public Issue ii) Offer For Sale iii) Private Placement iv) Right Issue v) Electronic-Initial Public Offer It comes before Secondary Market

PRIMARY MARKET In the primary market, governments, companies, or public sector organizations can obtain funding through the sale of a new stock or bonds. These are normally issued through securities dealers and banks, which underwrite the offered stocks or bonds. The issuers earn a commission, which is built into the price of the security offering. TYPES OF ISSUE A company can raise its capital through issue of share and debenture by means of :PUBLIC ISSUE :Public issue is the most popular method of raising capital and involves raising capital and fund direct from the public . RIGHT ISSUE :Right issue is the method of raising additional finance from existing members by offering securities to them on pro rata basis. A company proposing to issue securities on right basis should send a letter of offer to the shareholders giving adequate discloser as to how the additional amount received by the issue is used by the company.

BONUS ISSUE:-

Some companies distribute profits to existing shareholders by way of fully paid up bonus share in lieu of dividend. Bonus share are issued in the ratio of existing share held. The shareholder do not have to nay additional payment for these share .
PRIVATE PLACEMENT:The sale of securities to a relatively small number of select investors as a way of raising capital. Investors involved in private placements are usually large banks, mutual funds, insurance companies and pension funds. Private placement is the opposite of a public issue, in which securities are made available for sale on the open market.

The secondary market is that segment of the capital market where the outstanding securities are traded. From the investors point of view the secondary market imparts liquidity to the long term securities held by them by providing an auction market for these securities.

Secondary Market

The secondary market is that market in which the buying and selling of the previously issued securities is done.
The transactions of the secondary market are generally done through the medium of stock exchange. The chief purpose of the secondary market is to create liquidity in securities.

Features of Secondary Market


It Creates Liquidity It Comes After Primary Market It Has A Particular Place It Encourage New Investments

FUNCTIONS OF THE SECONDARY MARKET


1. To facilitate liquidity and marketability of the outstanding equity and debt instruments.

2. To contribute to economic growth through allocation of funds to the most


efficient channel through the process of disinvestments to reinvestment. 3. To provide instant valuation of securities caused by changes in the internal environment (that is, company-wide and industry wide factors). Such valuation facilitates the measurement of the cost of capital and the rate of return of the economic entities at the micro level. 4. To ensure a measure of safety and fair dealing to protect investors interest. 5. To induce companies to improve performance since the market price at the stock exchanges reflects the performance and this market price is readily available to investors.

Money Market
The money market is a wholesale debt market for low-risk, highly

liquid, short-term instrument. This market is dominated mostly by government, banks and financial institutions. The money market is a market for lending and borrowing of short-term funds. Money market deals in funds and financial instrument having a maturity period of one day to one year. The instruments in the money market are close substitutes for money as they are of short-term nature and highly liquid. Money market is not a place (like the stock market). It is in fact, a mechanism undertaken by telephone. Also, it is a collection of markets for several financial instruments such as call money market, commercial bill market, etc

FUNCTIONS OF MONEY MARKET: 1. To channelize savings into short term productive investments like working capital. 2. It facilitates economic development through provision of short term funds to industrial and other sectors. 3. It provides a mechanism to achieve EQUILIBRIUM between DEMAND and SUPPLY of short-term funds. 4. It facilitates effective implementation of the RBIs monetary policy. 5. It provides ample avenues for short-term fundswith fair returns to investors. 6. It instills financial discipline in commercial banks. 7. It provides funds to meet short term needs. 8. It enhances capital formation through savings and investment. 9. Short-term allocation of funds is made possible through inter-bank transactions and money market instruments. 10. It helps in employment generation. 11. It provides funds to government to meet its deficits. 12. It helps to control inflation.

Instruments in Money Market


Call money market
Treasury bills market Markets for commercial paper Certificate of deposits Bills of Exchange

Money market mutual funds


Promissory Note

Financial Instruments Financial Instruments


Primary Securities
Equity, Preference shares, Debt

Secondary Securities
Time deposits, MF units Insurance policies
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Financial Instruments
Another important constituent of financial system is financial instruments. They represent a claim against the future income and wealth of others. It can be a claim against a person or an institutions, for the payment of a sum of money at a specified future date. Enable channelizing funds from surplus units to deficit units There are instruments for savers such as deposits, equities, mutual fund units, etc. There are instruments for borrowers such as loans, overdrafts, etc. Like businesses, governments too raise funds through issuing of bonds, Treasury bills, etc. Instruments like PPF, KVP, etc. are available to savers who wish to lend money to the government

EQUITY SHARES means that part of the share capital of the company which are not preference shares. The majority of Share Capital will be raised through the issue of Ordinary Shares. Ordinary Shareholders, are the legal owners of the business, and are entitled to full shareholder voting rights at meetings - the Annual General Meeting (A.G.M.), or at Extra-Ordinary General Meetings (E.G.M.s). They are entitled to receive returns out of the companies profit, in the form of Dividends.

FEATURES OF EQUITY SHARES


1. Right to control 2. Voting rights 3. Claim on income 4. Claim on assets 5. Limited liability

PREFERENCE SHARES means shares which fulfill the following 2 conditions. Therefore, a share which is does not fulfill both these conditions is an equity share. It carries Preferential rights in respect of Dividend at fixed amount or at fixed rate i.e. dividend payable is payable on fixed figure or percent and this dividend must paid before the equity shares holders dividend. It also carries preferential right in regard to payment of capital on winding up or otherwise. It means the amount paid on preference share must be paid back to preference shareholders before anything is paid to the equity shareholders. In other words, preference share capital has priority both in repayment of dividend as well as capital. Types of Preference Shares 1.Cumulative or Non-cumulative preference shares 2.Redeemable and Non- Redeemable preference shares 3.Participating Preference Share or non-participating preference shares 4. Convertible and non-convertible preference shares Features of preference shares Fixed dividend Convertibility Voting rights Cumulative dividend Redemption

DEBENTURE: When a company intends to raise the loan amount from the public it issues debentures. A person holding debenture or debentures is called a debenture holder. A debenture is a document issued under the seal of the company. It is an acknowledgment of the loan received by the company equal to the nominal value of the debenture. It bears the date of redemption and rate and mode of payment of interest. A debenture holder is the creditor of the company. Kinds of debentures 1. Non-convertible debentures 2. Fully convertible debentures 3. Partly convertible debentures 4. Redeemable and Irredeemable debentures 5. Secured and Unsecured debentures Features of debentures 1. Fixed rate of interest 2. Maturity 3. Security 4. Redemption 5. Claim on assets and income

Financial Services
Efficiency of emerging financial system largely depends upon the quality and variety of financial services provided by financial intermediaries. The term financial services can be defined as "activites, benefits and satisfaction connected with sale of money, that offers to users and customers, financial related value".
Fund or Asset based Services Leasing Hire Purchase Bill Discounting Venture Capital Housing Finance Insurance Factoring Fee or Advisory based Service Issue Management Portfolio Management Corporate Counseling Loan Syndication Merger and Acquisition Credit Rating Stock Broking Capital Restructuring

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