Chapter 1

Nature and Role of Financial System

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 To discuss the bare elements of a financial system.

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 Broad Issues

What are the necessary pre-conditions to define Financial

System?
Do the forces of demand & supply exist in a financial
system?
Is it possible to influence the level of national
income,employment,social wellbeing through variations in
the supply of finance?
In what way financial development itself is affected by
economic development?
Do the free & competitive financial markets allocate
resources more efficiently?

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 Enhances the rate of capital formation, efficiency of the
function of medium of exchange and facilitate
allocation of resources across space and time in an
uncertain environment

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 Facilitates separating ,distributing, trading, hedging,
diversifying, pooling and reducing risks
Allocates resources across space and time
Monitors managers and exerts corporate control
Mobilises saving
Facilitates efficient operation of payment mechanism
Enables economic units to exercise their time preference
Transmutes or transforms financial claims so as to suit

the preference of both savers and investors

Enhances liquidity & better portfolio management

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 Financial System : Money, Credit , Finance

The Structure of Financial system consists of :

specialised & non-specialised financial institutions

organised and unorganised financial markets
financial instruments and services which facilitates
transfer of funds

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Structure of Indian Financial System

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 The centers or arrangements that provide facilities for
demand and supply side of financial claims and services.

Classification of Financial Markets

Money & Capital Markets

Organised & Unorganised Markets
Primary & Secondary Markets
Formal & Informal Markets
Official & Parallel Markets
Domestic & Foreign Markets
Broad & Deep Financial Markets

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 Financial Assets
Financial securities (Primary & Secondary)

Investment characteristics of Financial assets

Liquidity Maturity period
Marketability Tax status
Reversibility Buy-back options
Transferability Volatility of prices
Transaction costs Rate of return
Risk of default

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 Equilibrium is established when the expected demand
for funds (credit) for short-term & long-term
investment matches with the planned supply of funds
generated out of savings and credit creation.
(Figure A,B &C )

Interest rate can also be fixed irrespective of the equilibrium

rate of interest i.e. Administered Interest rate (Figure D) in
order to match/adjust supply and demand for funds as per
economic policy requirement

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contd...

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 Finance ratio
Financial Inter-relation ratio
New issue ratio
Intermediation ratio
The ratio of money to national income
Proportion of current account deficit financed from market
Integration of financial sector development
Lower transaction cost
Developed banking sector with private ownership
Well developed supervisory system
Efficient & large non-banking sector
High level of current & capital account convertibility
Well developed secondary markets in all financial assets
More prominence of indirect rather direct technique of monetary
policy
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 Financial Sector & Economic Development

Theories on the impact of financial development on savings and

investment :

The classical prior voluntary

savings theory

Forced saving or Inflationary

Financing theory

Financial Repression theory

Financial Liberalisation theory

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 contd...
The role of financial system in the growth process : to
reduce the cost of accumulating capital.

Policy makers should align private incentives with public

interest in such a way that the scrutiny of financial institutions by
supervisors is supported by supervision of market participants :
Market-aware regulation
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 contd...

Possible pattern of relationship : Financial

development & Economic development is symbiotic

Demand following financial development

Economic Growth cycle

Supply leading financial development

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 Little investment in financial market is based genuine long-term
expectations. ( Keynes)

Practical implication of Efficient market.(Tobin's)

Financial markets hardly conform to a model of perfect
competition

The casino effect of the financial market

Crowed behavior of the market: growing deviation from
equilibrium prices (boom & bust)

Investor behavior: trade on noise rather than fundamentals

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 contd...

The relation between capital and growth : Correlation

Vs. causation

Demand side of investment rather supply of funds may

be the decisive element in take off ( Rostow)

Real growth can not be bought with money alone

(Chandler)

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 Whether institutions find the most productive
investment?
Do institutions revalue their assets & liabilities in
response to changed circumstances?
Whether Institutions facilitate the management of risk?
Whether financial institutions transparent in
communication?
How effective is the regulatory and supervisory
system?
Do investors and financial institutions learn from past
mistakes?

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 Efficiency a. Information Arbitrage
b. Fundamental Valuation Efficiency
c. Full Insurance Efficiency
d. Operational Efficiency
e. Allocation Efficiency

Financial Innovations
Financial Engineering
Financial Revolution
Diversification
Financial Repression
Financial Integration
Securitisation
Braod,Wide,Deep and shallow market

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