Financial System

Introduction to Financial Systems

In finance, the financial system is the system that allows the transfer of money
between savers and borrowers it comprises a set of complex and closely interconnected
financial institutions, markets, instruments, services, practices, and transactions. Financial
systems are crucial to the allocation of resources in a modern economy. They channel
household savings to the corporate sector and allocate investment funds among firms.
The functions are common to the financial systems of most developed economies. Yet the
form of these financial systems varies widely.

The financial system or the financial sector of any country consists of:-

(A) Specialized & non specialized financial institution.

(B) Organized &unorganized financial markets and,

(C) Financial instruments & services which facilitate transfer of funds.

Procedure & practices adopted in the markets, and financial inter relationships are
also the parts of the system. These parts are not always mutually exclusive. The word
system in the term financial system implies a set of complex and closely connected or
inters mixed institution, agent’s practices, markets, transactions, claims, & liabilities in
the economy. The financial system is concerned about money, credit, & finance – the
terms intimately related yet some what different from each other. Money refers to the
current medium of exchange or means of payment. Credit or Loan is a sum of money to
be returned normally with interest it refers to a debt of economic unit. Finance is a
monetary resources comprising debt & ownership fund of the state, company or person.

DEFINITION
“In finance, the financial system is the system that allows the transfer of money
between savers and borrowers. It comprises a set of complex and closely interconnected
financial institutions, markets, instruments, services, practices, and transactions.”

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Financial System

Features of Financial System

 It provides an Ideal linkage between depositor’s savers and investors
Therefore it encourages savings and investment.

 Financial system facilitates expansion of financial markets over a period of

time.

 Financial system should promote deficient allocation of financial resources

of socially desirable and economically productive purpose.

 Financial system influence both quality and the pace of economic

development.

Role of Financial System

The role of the financial system is to promote savings & investments in the
economy. It has a vital role to play in the productive process and in the mobilization of
savings and their distribution among the various productive activities. Savings are the
excess of current expenditure over income. The domestic savings has been categorized
into three sectors, household, government & private sectors.

The function of a financial system is to establish a bridge between the savers and
investors. It helps in mobilization of savings to materialize investment ideas into realities.
It helps to increase the output towards the existing production frontier. The growth of the
banking habit helps to activate saving and undertake fresh saving. The financial system
encourages investment activity by reducing the cost of finance risk. It helps to make
investment decisions regarding projects by sponsoring, encouraging, export project
appraisal, feasibility studies, monitoring & execution of the projects.

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Financial System

Indian Financial System

India stands on the cusp of the millennium, having largely completed a first phase
of financial sector reforms and in need of a second phase to meet some remaining and
new challenges. The first phase — liberalization of interest rate and directed credit —
began in the early 1990s, hand-in-hand with real sector deregulation. With prices in the
real economy reflecting economic costs more closely and with greater reliance on the
private sector, it naturally became important to move from a financial system that was
largely an arm of public finance carrying out centralized, directed credit allocations to a
system where financial institutions played a much greater role in allocating resources
based on their evaluation of risk and return. Cross-country evidence suggests that the new
approach should contribute to faster overall development.

India has a financial system that is regulated by independent regulators in the

sectors of banking, insurance, capital markets, competition and various services sectors.
In a number of sectors Government plays the role of a regulator.

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Financial System

Introduction to Financial Markets

Financial Markets are an important component of financial system in an economy

financial system aims at establishing a regular, smooth, efficient and cost effective link
between savers & investors. Thus, it helps encouraging both saving and investment. All
system facilitates expansion of financial markets over space 8 times and promotes
efficient allocation of financial resources .For socially desirable and economically
productive purposes. They influence both the quality and the pace of economic
development.

Various constituents of financial system are financial, institutions, financial

services, financial instruments and financial markets. These constituents of financial
system are closely inter-mixed and operate in conjunction with each other. For eg.
Financial institutions operate in financial markets generating, purchasing and selling
financial instruments and rendering various financial services in accordance with the
practices and procedures established by law or tradition.

Financial markets are the centre or arrangements facilitating buying and selling of
financial claims, assets, services and the securities. Banking and non – banking financial
institutions, dealers, borrowers and lenders, investors and savers, and agents are the
participants on demand and supply side in these markets. Financial market may be
specific place or location, e.g. stock exchange or it may be just on over – the –phone
market.

Financial markets in India are classified into four parts, viz.:-

 Money Market
 Capital Market
 Debt Market
 Forex Market

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Introduction to Money Market

Whenever a bear market comes along, investors realize that the stock market is a
risky place for their savings. It's a fact we tend to forget while enjoying the returns of a
bull market! Unfortunately, this is part of the risk-return tradeoff. To get higher returns,
you have to take on a higher level of risk. For many investors, a volatile market is too
much to stomach - the money market offers an alternative to this higher-risk investment.

The money market is better known as a place for large institutions and government
to manage their short-term cash needs. However, individual investors have access to the
market through a variety of different securities. In this tutorial, we'll cover various types
of money market securities and how they can work in your portfolio.

The money market is a subsection of the fixed income market. We generally think

of the term fixed income as being synonymous to bonds. In reality, a bond is just one
type of fixed income security. The difference between the money market and the bond
market is that the money market specializes in very short-term debt securities (debt
that matures in less than one year). Money market investments are also called cash
investments because of their short maturities.

The easiest way for us to gain access to the money market is with money market
mutual funds, or sometimes through a money market bank account. These accounts and
funds pool together the assets of thousands of investors in order to buy the money market
securities on their behalf. However, some money market instruments, like Treasury bills,
may be purchased directly. Failing that, they can be acquired through other large
financial institutions with direct access to these markets. 

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Money Market Instruments

The money market is a market for short-term financial assets that are close
substitutes of money. The most important feature of a money market instrument is that it
is liquid and can be turned over quickly at low cost and provides an opportunity for
balancing the short-term surplus funds of lenders and the requirements of borrowers. By
convention, the term "Money Market" refers to the market for short-term requirement and
deployment of funds. Money market instruments are those instruments, which have a
maturity period of less than one year. The most active part of the money market is the
market for overnight call and term money between banks and institutions and repo
transactions. Call Money / Repo are very short-term Money Market products. There is a
wide range of participants (banks, primary dealers, financial institutions, mutual funds,
trusts, provident funds etc.) dealing in money market instruments. Money Market
Instruments and the participants of money market are regulated by RBI and SEBI.As a
primary dealer SBI DFHI is an active player in this market and widely deals in Short
Term Money Market Instruments. T he below mentioned instruments is normally termed
as money market instruments: 

 Repo/ Reverse Repo

 Inter Corporate Deposits
 Commercial Paper
 Certificate of Deposit 
 T-Bill

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 Treasury Bills: 
The Treasury bills are short-term money market instrument that mature in
a year or less than that. The purchase price is less than the face value. At maturity the
government pays the Treasury bill holder the full face value. The Treasury Bills are
marketable, affordable and risk free. The only downside to T-bills is that you won't get a
great return because Treasuries are exceptionally safe. 
 Certificate of Deposit (CD)
The certificates of deposit are basically time deposits that are issued by
the commercial banks with maturity periods ranging from 3 months to five years. The
return on the certificate of deposit is higher than the Treasury Bills because it assumes a
higher level of risk. 
 Commercial Paper
Commercial Paper is short-term loan that is issued by a corporation use for
financing accounts receivable and inventories. The maturity period of Commercial Papers
is a maximum of 9 months. They are very safe since the financial situation of the
corporation can be anticipated over a few months. 
 Inter-Corporate Deposits
Inter-corporate deposits are deposits made by one company with another
company, and usually carry a term of six months. The three types of inter-corporate
deposits are: three month deposits, six month deposits, and call deposits. The biggest
advantage of inter-corporate deposits is that the transaction is free from bureaucratic and
legal hassles.
 Repo/Reverse Repo
Repo is short for repurchase agreement. Those who deal in government
securities use repos as a form of overnight borrowing. They are usually very short-term,
from overnight to 30 days or more. The reverse repo is the complete opposite of a repo.

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In this case, a dealer buys government securities from an investor and then sells them
back at a later date for a higher price.
Introduction to 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. Capital market is the market for long term sources of
finance. It refers to meet the long term requirements of the industry. Generally the
business concerns need two kinds of finance:-
1. Short term funds for working capital requirements.
2. Long term funds for purchasing fixed assets.
Therefore the requirements of working capital of the industry are met by the
money market. The long term requirements of the funds to the corporate sector are
supplied by the capital market. It refers to the institutional arrangements which facilitate
the lending & borrowing of long term funds.
On the basis of financial instruments the capital markets are classifieds into
Two kinds:-
a) Equity market
b) Debt market
Recently there has been a substantial development of the India capital market. It
comprises various submarkets.
Equity market is more popular in India. It refers to the market for equity shares of
existing & new companies. Every company shall approach the market for raising of
funds. The equity market can be divided into two categories
(a) Primary market
(b) Secondary market.

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Primary Market
The primary market is that part of the capital markets that deals with the issue of
new securities. Companies, governments or public sector institutions can
obtain funding through the sale of a new stock or bond issue. This is typically done
through a syndicate of securities dealers. The process of selling new issues to investors is
called underwriting. In the case of a new stock issue, this sale is an initial public
offering (IPO). Dealers earn a commission that is built into the price of the security
offering, though it can be found in the prospectus. Primary markets create long term
instruments through which corporate entities borrow from capital market. 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.

Bonus Issue:-

Some companies distribute profits to existing shareholders by way of fully

paid up bonus share in lieu of dividend. The shareholder does not have to any
additional payment for these shares.

Private Placement:-

Private placement market financing is the direct sale by a public limited

company or private limited company of private as well as public sector of its

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securities to the intermediaries like credit rating agencies and trustees and financial
advisors such as merchant bankers.

Secondary 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. The secondary market operates through the medium of stock exchange
which regulates the trading activity in this market and ensures a measure of safety and
fair dealing to the investors. India has a long tradition of trading in securities going back
to nearly 200 years. The first India stock exchange established at Mumbai in 1875 is the
oldest exchange in Asia. The main objective was to protect the character status and
interest of the native share and stock broker.

The Indian stock markets can be divided into further categories depending on
various aspects like the mode of operation and the diversification in services. First of the
two largest stock exchanges in India can be divided on the basis of operation. While the
Bombay stock exchange or BSE is a conventional stock exchange with a trading floor
and operating through mostly offline trades, the National Stock Exchange or NSE is a
completely online stock exchange and the first of its kind in the country. The trading is
carried out at the National Stock Exchange through the electronic limit order book or the
LOB. With the immense popularity of the process and online trading facility other
exchanges started to take up the online route including the BSE where you can trade
online as well. But the BSE is still having the offline trading facility that is carried out at
the trading floor of the exchange at its Dalal Street facility.

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Financial System

Introduction to Debt Market

Debt market refers to the financial market where investors buy and sell debt
securities, mostly in the form of bonds. These markets are important source of funds,
especially in a developing economy like India. India debt market is one of the largest in
Asia. Like all other countries, debt market in India is also considered a useful substitute
to banking channels for finance. The fixed return on the bond is often termed as the
'coupon rate' or the 'interest rate'.

The debt market often goes by other names, based on the types of debt instruments

that are traded. In the event that the market deals mainly with the trading of municipal
and corporate bond issues, the debt market may be known as a bond market. If mortgages
and notes are the main focus of the trading, the debt market may be known as a credit
market. When fixed rates are connected with the debt instruments, the market may be
known as a fixed income market.

The instruments traded can be classified into the following segments based on
the characteristics of the identity of the issuer of these securities:

Market Segment Issuer Instruments

Government Central Government Zero Coupon Bonds, Coupon Bearing Bonds, Treasury
Securities Bills, STRIPS

State Governments Coupon Bearing Bonds.

Public Sector Bonds Government Agencies / Govt. Guaranteed Bonds, Debentures

Statutory Bodies
Public Sector Units PSU Bonds, Debentures, Commercial Paper

Private Sector Corporate Debentures, Bonds, Commercial Paper, Floating Rate

Bonds Bonds, Zero Coupon Bonds, Inter-Corporate Deposits
  Banks Certificates of Deposits, Debentures, Bonds
  Financial Institutions Certificates of Deposits, Bonds

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Financial System

Introduction to Forex Market

In India, foreign exchange has been given a statutory definition. Section 2 (b) of
Foreign Exchange Regulation Act, 1973 states:

‘Foreign exchange’ means foreign currency and includes:

“All deposits, credits and balances payable in any foreign currency and any drafts,
traveler’s cheques, letters of credit and bills of exchange , expressed or drawn in Indian
currency but payable in any foreign currency.”

Particularly for foreign exchange market there is no market place called the
foreign exchange market. It is mechanism through which one country’s currency can be
exchange i.e. bought or sold for the currency of another country. The foreign exchange
market does not have any geographic location. The market comprises of all foreign
exchange traders who are connected to each other through out the world. They deal with
each other through telephones, telexes and electronic systems. With the help of Reuters
Money 2000-2, it is possible to access any trader in any corner of the world within a few
seconds.

Participants

1. Customers
The customers who are engaged in foreign trade participate in foreign exchange
markets by availing of the services of banks.
2. Commercial banks
Commercial banks dealing with international transactions offer services for
conversion of one currency in to another.
3. Central Bank
In all countries central banks have been charged with the responsibility of
maintaining the external value of the domestic currency.

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Financial System

Introduction to Financial Institutions

In financial economics, a financial institution is an institution that

provides financial services for its clients or members. Probably the most important
financial service provided by financial institutions is acting as financial intermediaries.
Most financial institutions are highly regulated by government
Financial institutions provide service as intermediaries of the capital and debt
markets. They are responsible for transferring funds from investors to companies in need
of those funds. Financial institutions facilitate the flow of money through the economy.
To do so, savings a risk brought to provide funds for loans. Such is the primary means for
depository institutions to develop revenue. Should the yield curve become inverse, firms
in this arena will offer additional fee-generating services including securities
underwriting.

The financial institutions in India are divided in two categories. The first type

refers to the regulatory institutions and the second type refers to the intermediaries. The
regulators are assigned with the job of governing all the divisions of the Indian financial
system. These regulatory institutions are responsible for maintaining the transparency and
the national interest in the operations of the institutions under their supervision. 

The regulatory bodies of the financial institutions in India are as follows: 

 Reserve Bank of India (RBI)

 Securities and Exchange Board of India (SEBI)
 Central Board of Direct Taxes (CBDT)
 Central Board of Excise & Customs

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Financial System

Apart from the Regulatory bodies, there are the Intermediaries that include the
banking and non-banking financial institutions. Some of the specialized financial
institutions in India are as follows: 

 Unit Trust of India (UTI)

 Securities Trading Corporation of India Ltd. (STCI)
 Industrial Development Bank of India (IDBI)
 Industrial Reconstruction Bank of India (IRBI), now (Industrial Investment Bank
of India)
 Export - Import Bank of India (EXIM Bank)
 Small Industries Development Bank of India (SIDBI)
 National Bank for Agriculture and Rural Development (NABARD)
 Life Insurance Corporation of India (LIC)

Intermediary Market Role

Secondary Market to
Stock Exchange Capital Market
securities
 Corporate advisory services,
Investment Bankers Capital Market, Credit Market
Issue of securities
Capital Market, Money Subscribe to unsubscribed
Underwriters
Market portion of securities
Issue securities to the
Registrars, Depositories, investors on behalf of the
Capital Market
Custodians company and handle share
transfer activity
Primary Dealers Satellite Market making in government
Money Market
Dealers securities
Ensure exchange ink
Forex Dealers Forex Market
currencies

 Thus, it can be concluded that a financial institution is that type of an institution,

which performs the collection of funds from private investors and public investors and
utilizes those funds in financial assets. The functions of financial institutions are not
limited to a particular country, instead they have also become popular in abroad due to
the growing impact of globalization.  

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Financial System

Introduction to Financial Instruments

A real or virtual document representing a legal agreement involving some sort of
monetary value. In today's financial marketplace, financial instruments can be classified
generally as equity based, representing ownership of the asset, or debt based, representing
a loan made by an investor to the owner of the asset. Foreign exchange instruments
comprise a third, unique type of instrument. Different subcategories of each instrument
type exist, such as preferred share equity and common share equity, for example.
Financial products refer to those instruments that help you save, invest, get
insurance or get a mortgage. These are issued by various banks, financial institutions,
stock brokerages, insurance providers, credit card agencies and government sponsored
entities. Financial products are categorized in terms of their type or underlying asset
class, volatility, risk and return.
The major types of financial products are:
Shares:
These represent ownership of a company. While shares are initially issued by
corporations to finance their business needs, they are subsequently bought and sold by
individuals in the share market. They are associated with high risk and high returns.
Returns on shares can be in the form of dividend payouts by the company or profits on
the sale of shares in the stock market. Shares, stocks, equities and securities are words
that are generally used interchangeably.

Bonds:
These are issued by companies to finance their business operations and by
governments to fund expenses like infrastructure and social programs. Bonds have a
fixed interest rate, making the risk associated with them lower than that with shares. The
principal or face value of bonds is recovered at the time of maturity.

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Treasury Bills
These are instruments issued by the government for financing its short term
needs. They are issued at a discount to the face value. The profit earned by the investor is
the difference between the face or maturity value and the price at which the Treasury Bill
was issued.

Options
Options are rights to buy and sell shares. An option holder does not actually
purchase shares. Instead, he purchases the rights on the shares.

Mutual Funds
These are professionally managed financial instruments that involve the
diversification of investment into a number of financial products, such as shares, bonds
and government securities. This helps to reduce an investor’s risk exposure, while
increasing the profit potential.

Credit Default Swaps (CDS)

Credit default swaps are highly leveraged contracts that are privately negotiated
between two parties. These swaps insure against losses on securities in case of a default.
Since the government does not regulate CDS related activities, there is no specific central
reporting mechanism that determines the value of these contracts.

Annuities
These are contracts between investors and insurance companies, wherein the latter
makes periodic payments in exchange for financial protection in the event of an
unfortunate incident.

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Financial System

Introduction to Financial Services

Financial services encompass a variety of businesses that deal with money

management. These include many different kinds of organizations such as banks,
investment companies, credit card companies, insurance companies and even government
programs. Financial services can also refer to the services and products that money
management organizations offer to the public.

Banks are one kind of financial services organizations. Banks generally function

by providing a sheltered and secure place for people to store their money. Usually, banks
will invest their clients' stored money for the bank's gain, while paying a small amount of
interest to those who keep their money in savings or checking accounts.

The Financial services were developed in order to meet the needs of individual as
well as companies. The financials of companies are expected to improve as a result of
these financial services in the form of lower debt equity ratio, improved liquidity and
profitability ratios. The financial service industry has been growing at a rate of 14% per
annum.

Indian financial services industry was rather unexciting until the early seventies.
The financial services sector was started in mid seventies when a series of innovative
services of which leasing being the most notable. India has witnessed an explosive
growth of leasing companies during the early eighties.

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Financial System

Financial service is a very wide field. However, we can classify these services in
the following groups:

(A)Banking and Financial Services:

Banking and financial services can also be further classified as:

1. Fee based financial services

 Financial management.

 Advisory services

 Custody services

 Credit card services

2. Securities-related financial services

 Securities lending services

 Mutual fund services

 Securities clearance

 Settlement services

 Under-writing services

(B)Insurance and insurance related services

Insurance services include the following:

 Insurance brokerage

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 Specialty insurance products

 Reinsurance

(C)Fee-based Financial Services

Financial services based on fees are as follows:

 Issue management

 Portfolio management

 Loan based syndication

 Mergers and acquisitions

(E)Capital market Services

The following are the financial services rendered by various intermediaries in

relation to capital market.

1. Issue management

Public issue management is the beginning of project financing activity. A

company has to appoint public issue managers who are normally merchant bankers. It is a
marketing activity.

2. Merchant banking

A merchant banker is any person who is engaged in the business of issue management
either by making arrangements regarding selling, buying or subscribing to securities as

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Financial System

manager, consultant or advisor or vendoring corporate advisory services in relation to

such issue management

Services provided by Merchant Bankers

 Underwriting of issues

 Project finance

 Private placements

Conclusion

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.

“While finance is the lifeblood --- financial system is the network of arteries and
veins carrying blood to various parts of the body”

In India money market is regulated by Reserve bank of India and Securities

Exchange Board of India (SEBI) regulates capital market. Capital market consists of
primary market and secondary market. All Initial Public Offerings comes under the
primary market and all secondary market transactions deals in secondary market.
Secondary market refers to a market where securities are traded after being initially
offered to the public in the primary market and/or listed on the Stock Exchange.
Secondary market comprises of equity markets and the debt markets. In the secondary
market transactions BSE and NSE plays a great role in exchange of capital market
instruments.

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The banking institutions of India play a major role in the economy of the country.
The banking institutions are the providers of depository and transaction services. These
activities are the major sources of creating money. The banking ins titutions are the major
sources of providing loans and other credit facilities to the clients. 

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