Financial System

Finance (Noun, Verb)  The American Heritage® Dictionary of the English Language, Fourth Edition defines the term as under 1:"The science of the management of money and other assets."; 2: "The management of money, banking, investments, and credit. "; 3: "finances Monetary resources; funds, especially those of a government or corporate body" 4: "The supplying of funds or capital."

Financial System
Finance as a function (i.e. verb) is defined by the same dictionary as under 1:"To provide or raise the funds or capital for": financed a new car 2: "To supply funds to": financing a daughter through law school. 3: "To furnish credit to".  :"the commercial activity of providing funds and capital" 4: "the branch of economics that studies the management of money and other assets" 5: "the management of money and credit and banking and investments"

Financial System
 System:

Set of complex and closely connected or

interlinked institutions, agents, practices, markets, transactions, claims, and liabilities in the economy
 Financial

System: Money, Credit, Finance  Heart to human body: Important for Economy
A financial system functions as an intermediary and facilitates the flow of funds from the areas of surplus to the areas of the deficit.

Generally accepted as payment for goods and services and repayment of debts Functions of money: Medium of Exchange Unit of Account Store of value Standard of deferred payment Money forms: Commodity Money and Fiat Money

Measures of Money
M1:Currency (coins and bills) and checking account deposits M2: Currency, checking account deposits and savings account deposits M3: M2 plus time deposits M0: Currency plus deposits of banks and other institutions at the central bank


Loaned A method of paying for goods or services at a later time, usually paying interest as well as the original money


by which claims to resources are either assembled from those released by domestic savings, obtained from abroad, or specifically created usually as bank deposits or notes and then placed in the hands of investors.


by which resources are actually committed to production Volume of capital formation: Intensity of savings, finance and investment. Conversion of savings to investment: Transfer Process

Transfer Process
Genesis of Financial System: Divorce between savings and investment  Relationship between savings and investment vary considerably among economic units  Goldsmith’ designated categories of economic units: Savings-surplus units (Savings in excess of investments), Economic Units (Investments exceed their savings) and Neutral units (Savings equal to investments)

Financial System

Function of efficient allocation of funds

innovation Growth of technology Rudimentary Finance Direct Finance Indirect Finance

Rudimentary Finance

System of underdeveloped or traditional economy Per capita output low and declining Absence of an array of financial assets/ instruments that would stimulate savings Absence of an array of financial markets that would allocate savings competitively to investment

Direct Finance

over rudimentary finance by removing the obstacles to efficient capital formation Improved capital formation under direct finance through: Financial assets/ instruments, Brokers/ Investment Bankers, Secondary Markets/ Stock Exchanges

Financial Assets/ Instruments (Securities)

instrument/ asset is a claim against another economic unit and is held as a store of value and for the return that is expected. Examples: Shares, Debentures, etc. Financial assets stimulate capital formation and speedy economic development

Brokers/ Investment Bankers

savers and bring them with economic units needing funds Brokerage function, Underwriting function

Secondary Markets/ Stock Exchanges/ Markets

savers with ability/ facility to dispose of their investment portfolio and realise cash to finance their current consumption Provide liquidity and marketability

Indirect Finance
Flow of savings from savers to entrepreneurs through intermediary financial institutions like mutual funds, insurance companies, etc.  Services offered by financial intermediaries:  Convenience (Divisibility, Flexibility, Maturity)  Lower risk  Expert Management  Economies of Scale  Channelisation of savings (Encouraging, Sponsoring, Discriminating between various industries)

Financial System

Saving Function Liquidity Function Payment Function Risk Function Policy Function

Saving Function

saving 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 with the producers result in production of goods and services thereby increasing society living standards.

Liquidity Function

financial markets provide the investor with the opportunity to liquidate investments like stocks, bonds, debentures, etc. whenever they need the fund.

Payment Function

financial system offers a very convenient mode for payment of goods and services. Cheque system, credit card system etc are the easiest methods of payments. The cost and time of transactions are drastically reduced.

Risk Function

financial markets provide protection against life, health and income risks. These are accomplished through the sale of life and health insurance and property insurance policies. The financial markets provide immense opportunities for the investor to hedge himself against or reduce the possible risks involved in various investments

Policy Function

government intervenes in the financial system to influence macroeconomic variables like interest rates or inflation so if country needs more money government would cut rate of interest through various financial instruments and if inflation is high and too much money is there in the system then government would increase rate of interest.

Financial System: Composition

Intermediary Stock Exchange

Financial System: Intermediary
Market Role Capital Market Secondary Market to securities Capital Market, Credit Corporate advisory Market services, Issue of securities Capital Market, Money Subscribe to Market unsubscribed portion of securities Capital Market Issue securities to the investors on behalf of the company and handle share transfer activity Market making in government securities Ensure exchange ink

Investment Bankers


Registrars, Depositories, Custodians

Primary Dealers Satellite Dealers Forex Dealers

Money Market

Forex Market

Indian Financial System Phases

1951 !951 to the mid-eighties After early nineties


as the market in which financial assets are created or transferred.


assets represent a claim to the payment of a sum of money sometime in the future and/or periodic payment in the form of interest or dividend.


Money market

(Short term instrument)
Capital markets

(Long term instrument)


most important distinction between the two:
The difference in the period of maturity.



To channelize savings into short term productive

investments like working capital .


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


of the national money market day surplus funds mainly of banks are



term in nature of these loans vary from 1 to 15 days

Maturity Lent Lent

for 1 day: Call money

for more than 1 day but less than 15 days: Notice money
Convenient Highly

interest rate

liquid loan repayable on demand

Unsecured Issued

Promissory note.

by well known companies with strong and high credit rating.

directly by the issuers to investors or through agents like merchant banks and security houses.
Flexible Low


interest rates with compared to banks. a degree of financial stability to the


Referred It

as note payable in accounting

is a contract detailing the terms of a promise by one party (the maker) to pay a sum of money to the other (the payee).

obligation may arise from the repayment of a loan or from another form of debt.

example, in the sale of a business, the purchase price might be a combination of an immediate cash payment and one or


as short term deposit by way of usance promissory notes.

flexibility to investors in the deployment of surplus funds.
Permitted Maturity

by the RBI to banks

of not less than 3 months and upto in nature

1 year.
Transferable Free

negotiability and limited flexibility


primarily in money market instruments of very high quality.

and public financial institution can set it either directly or through its existing subsidiaries.

Open Ended Close Ended


resources needed by medium and large scale industries.

for these resources

Expansion Capacity Expansion Investments Mergers and Acquisitions

in long term instruments and sources of funds



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.

Primary Markets

Secondary Markets

When companies need financial The place where such securities are resources for its expansion, they borrow traded by these investors is known as the money from investors through issue of secondary market. securities. Securities issued a)Preference Shares b)Equity Shares c)Debentures Securities like Preference Shares and Debentures cannot be traded in the secondary market.

Equity shares is issued by the under Equity shares are tradable through a writers and merchant bankers on behalf private broker or a brokerage house. of the company. People who apply for these securities are: a)High networth individual b)Retail investors c)Employees d)Financial Institutions e)Mutual Fund Houses f)Banks One time activity by the company. Securities that are traded are traded by the retail investors.

Helps in mobilising the funds for the investors in the short run.

Components of Indian Financial System

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

Indian Financial System

International Financial Market
Financial Markets Foreign Exchange and Eurocurrency market Domestic and International Bond Market Domestic and International Stock Markets Derivatives Markets

Important Characteristic of Financial Markets

The ease of capturing an asset’s value Reflects a market’s operational efficiency Impacts a market’s informational and allocational efficiency  The inter bank foreign exchange market for large transactions is the world’s most liquid market

Other Market Characteristics

Short-term: Money market  Long-term: Capital market
 Single-country


internal markets  Multi-country external markets
 Intermediated


through a commercial bank  Non-intermediated or direct to the public, through a broker or investor bank

Foreign Exchange Markets conducted through commercial banks
Spot Market Cash market with delivery in two business days Forward Market Trade at a prearranged date and price

Intermediated Markets in bank deposits and loans
Money Markets Capital Markets

Internal Short term accounts Long term accounts Markets with domestic clients with domestic clients External Eurocurrency deposits Long term accounts markets and loans with foreign clients

Non-intermediated (Direct) markets
Money Markets Capital markets

Internal Markets External markets

Short term Commercial Paper Eurocommercial paper

Stocks and bonds issued in the domestic market Global equity, foreign bonds and Euro bonds

Eurocurrency Markets
Eurocurrencies: Bank deposits and loans residing outside any single country Floating rate pricing usually with maturities less than five years Few regulatory restrictions because they are outside the jurisdiction of any single government Competitive pricing – outstanding in 2.5 trillion dollars

Few regulations in eurocurrency market

Typically there are


reserve requirement No interest rate regulations or caps No with holding taxes No deposit insurance requirements No credit allocation regulations Less stringent disclosure requirements

Floating rate pricing in eurocurrency market

interest rate risk: Interest rates tied to a variable rate base such as the LIBOR Low default risk: Traded between large commercial banks, investment banks and multinational corporations Relatively short maturities: Typically less than five years

Global Equity offerings

listing of shares: Increase demand and enhance share price, Improves image of the firm, Gets more customer and investor base Cross listing benefits the firm in improving transparency and disclosure, reduces opportunity for hostile takeover. Dominant: 56 per cent

International Bond Market
 Domestic

Bonds Foreign Bonds Euro Bonds: Samurai, Bull dog, Yankee USA dominant: 31 per cent

Derivatives Market
Forwards Swaps Options Futures