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The Indian Financial

Copyright© 2008 Dorling Kindersley India Pvt. Ltd


System
Markets, Institutions and
Services
Second Edition

Bharati V. Pathak

The Indian Financial System, 2e -- Pathak


Copyright© 2008 Dorling Kindersley India Pvt. Ltd
1
Financial System: An Introduction

The Indian Financial System, 2e -- Pathak


The Indian Financial System

Copyright© 2008 Dorling Kindersley India Pvt. Ltd


The Indian Financial System, 2e -- Pathak
Chapter Objectives

Copyright© 2008 Dorling Kindersley India Pvt. Ltd


To understand the

 meaning of financial system


 components of the financial system
 functions of the financial system
 key elements of the financial system
 key elements of a well functioning financial
system
 bank-based and market-based financial
systems
 nature and role of financial institutions and
markets
 link between money market and capital
market
 link between primary market and secondary
The Indian Financial System, 2e -- Pathak
market
Meaning of the Financial
System

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 A set of sub systems of financial
institutions, markets, instruments and
services
 Intermediates with the flow of funds
between savers and borrowers.
 Facilitates transfer and allocation of scarce
resources efficiently and effectively

The Indian Financial System, 2e -- Pathak


Types of Financial
System

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 Formal financial system – organized,
institutional and regulated

 Informal financial system


Advantages
Low transaction costs
Minimum default risk
Transparency of procedures
Disadvantages
Wide range of interest rates
Higher rates of interest
Unregulated

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Components of the Financial
System

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 Financial Institutions

 Financial Markets

 Financial Instruments

 Financial Services

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Types of Financial
Institutions

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 Banking: creators and purveyors of credit.
Types
Commercial Banks
Cooperative Banks
 Non-banking: purveyors of credit
Types
Developmental financial
institutions
Mutual funds
Insurance companies
NBFCs

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Functions of Financial
Institutions

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Provide three transformation services

 Liability, asset and size transformation

 Maturity transformation

 Risk transformation

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Financial Markets

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Types
 Money Market – A market for short-term debt
instruments
 Capital Market – A market for long-term equity
and debt instruments

Segments
 Primary Market – A market for new issues
 Secondary Market – A market for trading
outstanding issues

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Link Between Primary and
Secondary Capital Market

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 A buoyant secondary market is
indispensable for the presence of a
vibrant primary market.

 The secondary market provides a basis for


the determination of prices of new issues.

 Depth of the secondary market depends on


the primary market.

 Bunching of new issues affects prices in the


secondary market.

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Financial Instruments

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Types

Primary

Secondary

Distinct Features

Marketable

Tradable

Tailor-made

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Financial Services

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Major Categories
Funds intermediation

Payments mechanism

Provision of liquidity

Risk management

Financial engineering

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Functions of Financial
System

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Mobilise and allocate savings
Monitor corporate performance
Provide payment and settlement systems
Optimum allocation of risk bearing and
reduction
Disseminate prize related information
Offer portfolio adjustment facility
Lower the cost of transactions
Promote the process of financial deepening
and broadening

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Key Elements of a Well-
functioning Financial System

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A strong legal and regulatory
environment
Stable money
Sound public finances and public debt
management
A central bank
Sound banking system
Information system
Well-functioning securities market

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Financial System Designs

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Types
Bank-based

Market-based

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Market-based Financial
System
Advantages

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Provide attractive terms to both investors
and borrowers
Facilitate diversification
Allow risk sharing
Allow financing of new technologies

Drawbacks
Prone to instability
Exposure to market risk
Free-rider problem

The Indian Financial System, 2e -- Pathak


Bank-based Financial
System

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Advantages
Close relationships with parties
Provide tailor-made contracts
Efficient inter-temporal risk sharing
No free-rider problem

Drawbacks
Retards innovation and growth
Impedes competition

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Functions of Financial
Markets

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Enabling economic units to exercise their
time preference
Separation, distribution, diversification and
reduction of risk
Efficient payment mechanism
Providing information
Enhancing liquidity
Providing portfolio management services

The Indian Financial System, 2e -- Pathak