Unit-1 MFI&S

• What Is a Financial System?

• A financial system is a set of institutions, such as banks,
insurance companies, and stock exchanges, that permit the
exchange of funds. Financial systems exist on firm, regional,
and global levels.
• Borrowers, lenders, and investors exchange current funds to
finance projects, either for consumption or productive
investments, and to pursue a return on their financial assets.
The financial system also includes sets of rules and practices
that borrowers and lenders use to decide which projects get
financed, who finances projects, and the terms of financial
deals.
• In its simple meaning the term ‘finance’ refers to monetary resources & the
term ‘financing’ refers to the activity of providing required monetary
resources to the needy persons and institutions. The term ‘financial system’
refers to a system that is concerned with the mobilization of the savings of the
public and providing of necessary funds to the needy persons and institutions
for enabling the production of goods and/or for provision of services. Thus, a
financial system can be understood as a system that allows the exchange of
funds between lenders, investors, and borrowers. In other words, the system
that facilitates the movement of finance from the persons who have surplus
funds to the persons who need it is called as financial system.
• It consists of complex, closely related services, markets, and institutions used
to provide an efficient and regular linkage between investors and depositors.
Financial systems operate at national, global, and firm-specific levels. It
includes the public, private and government spaces and financial instruments
which can relate to countless assets and liabilities.
• The Indian financial system is one of the most
important components of the economy that are
responsible for supporting the growth and the
funds in the country. The system mainly comprises
the ideas related to development and growth by the
wisely decision-making process for both savings and
investments fields. The Indian financial system is a
formative idea that comprises multiple components
and a specific structure that is responsible for
utilizing the cash flow statements.
• Features/Characteristics/ Nature of Financial System
• 1. Financial system acts as a bridge between savers and borrowers
• 2. It consists of a set of inter-related activities and services 3. It
consists of both formal and informal financial sectors. The
existence of both formal and informal system is also called as
financial dualism.
• 4. It formulates capital, investment and profit generation
• 5. It is universally applicable at firm level, regional level, national
level and international level
• 6. It consists of financial institutions, financial markets, financial
services, financial instruments, financial practices and financial
transactions.
• Importance of Financial System
• 1. Provision of liquidity
• 2. Mobilization of savings
• 3. Size transformation/Capital formation
• 4. Maturity transformation
• 5. Risk transformation
• 6. Lowering of cost of transaction
• 7. Payment mechanism
• 8. Assisting new projects
• 9. Enable better decision making
• 10. Meet short and long term financial needs
• 11. Provide necessary finance to the Government
• 12. Accelerate the process of economic growth of the country
 Role in the process of Economic
Development of a Country
• Mobilizing Savings: The Financial System Mobilizes the Savings of the people by offering
appropriate incentives and by deepening and widening the financial structure. In other
words, the Financial System creates varieties of forms of savings so that savings can take
place according to the varying asset preferences of different classes of savers.
• Promoting Investments: For the Economic Growth of any Nation, investment is
essential. This investment has to flow from the financial system. In fact, the level of
investment determines the increase in output of goods and services and incomes in the
country.
• Encouraging Investment in Financial Assets: The dynamic role of the Financial System in
the Economic development is that it encourages savings to flow into financial assets
(Money and Monetary Assets) as against Physical Assets (Land, Gold and other goods
and Services).
• Allocating Savings on the Basis of National Priorities: The Financial System Allocates
the Savings in a more efficient manner so that the scarce capital may be more efficiently
utilized among the various alternative investments. In other words, it gives preference to
certain sectors, from the social and economic point of view, on the basis of national
priorities.
• Creating Credit: Large Financial Resources are needed for the Economic Development of a
nation. These resources are supplied by the Financial System not only in the form of liquid
cash but also in the form of ‘Created Money’ or ‘Deposit Money’ by creating credit and
thereby making available large resources to Finance Trade, Production, Distribution etc.
• Providing a Spectrum of Financial Assets: The Financial System provides a spectrum of
Financial Assets to meet the varied requirements and preference of house hole. Thus, it
enables them to choose their asset portfolios in such a way as to achieve a preferred mix of
Return, Liquidity and Risk.
• Financing Trade, Industry and Agriculture: All the Financial Institutions operating in a
Financial System take all efforts to ensure that no worthwhile project- is it in trade or
agriculture or industry-suffers due to lack of funds. Thus, they promote industrial and
agricultural development, which has a greater say on the Economic Development of a
Country.
• Providing Financial Services: Innovations have started appearing in the arena of Financial
Intermediations as well. The Financial Institutions play a very dynamic role in the economic
development of a country not only as a provider of finance, but also as a departmental store
of finance by offering varieties of innovative financial products and services to meet the ever
increasing demands of their clients both corporate and individuals.
• Encouraging Entrepreneurial Talents: The Financial
Institutions encourage the Managerial and Entrepreneurial
Talents in the economy by promoting the spirit of Enterprise
and Risk Taking Capacity.
• Developing Backward Areas: The Integral Policy of the
National Development Plans of every Country concentrates on
the development of relatively less developed areas called
Backward Areas. The Financial Institutions provide a package
of services, Infrastructure and Incentives conducive to a
healthy growth of industries in such backward areas and thus
they contribute for the uniform development of all regions in
a Country.
• Structure of Indian Financial System: There
are four main components of the Indian
Financial System. This includes:
• 1. Financial Institutions
• 2. Financial Assets/ instruments
• 3. Financial Services
• 4. Financial Markets
• 1. Financial Institutions- The Financial Institutions act as a
mediator between the investor and the borrower. The
investor’s savings are mobilised either directly or indirectly via
the Financial Markets. The main functions of the Financial
Institutions are as follows:
• A short term liability can be converted into a long term
investment
• It helps in conversion of a risky investment into a risk-free
investment
• Also acts as a medium of convenience denomination, which
means, it can match a small deposit with large loans and a
large deposit with small loans.
• The financial institutions can further be divided into
two types: Banking Institutions or Depository
Institutions – This includes banks and other credit
unions which collect money from the public against
interest provided on the deposits made and lend that
money to the ones in need.
• Non-Banking Institutions or Non-Depository Institutions
– Insurance, mutual funds and brokerage companies
fall under this category. They cannot ask for monetary
deposits but sell financial products to their customers.
• 2. Financial Assets- The products which are traded
in the Financial Markets are called Financial Assets.
Based on the different requirements and needs of
the credit seeker, the securities in the market also
differ from each other. Some important Financial
Assets have been discussed briefly below:
• Call Money – When a loan is granted for one day
and is repaid on the second day, it is called call
money. No collateral securities are required for this
kind of transaction.
• Notice Money – When a loan is granted for more
than a day and for less than 14 days, it is called
notice money. No collateral securities are required
for this kind of transaction.
• Term Money – When the maturity period of a
deposit is beyond 14 days, it is called term money.
• Treasury Bills – Also known as T-Bills, these are
Government bonds or debt securities with maturity
of less than a year. Buying a T-Bill means lending
money to the Government.
• Certificate of Deposits – It is a dematerialized
form (Electronically generated) for funds
deposited in the bank for a specific period of
time.
• Commercial Paper – It is an unsecured short-
term debt instrument issued by corporations.
• 3. Financial Services-Services provided by Asset Management and Liability
Management Companies. They help to get the required funds and also make
sure that they are efficiently invested. The financial services in India include:
• Banking Services – Any small or big service provided by banks like granting a
loan, depositing money, issuing debit/credit cards, opening accounts, etc.
• Insurance Services – Services like issuing of insurance, selling policies,
insurance undertaking and brokerages, etc. are all a part of the Insurance
services
• Investment Services – It mostly includes asset management
• Foreign Exchange Services – Exchange of currency, foreign exchange, etc.
are a part of the Foreign exchange services
The main aim of the financial services is to assist a person with selling,
borrowing or purchasing securities, allowing payments and settlements and
lending and investing.
• 4. Financial Markets The marketplace where buyers and sellers interact with
each other and participate in the trading of money, bonds, shares and other
assets is called a financial market. The financial market can be further divided
into four types:
• The organised sector is made up of businesses that follow government
guidelines and regulations. They are usually larger businesses with more
resources.
• The unorganised sector, on the other hand, is made up of small businesses that
do not follow government guidelines or regulations.
• Capital Market – Designed to finance the long term investment, the Capital
market deals with transactions which are taking place in the market for over a
year. The capital market can further be divided into three types:
• (a)Corporate Securities Market
• (b)Government Securities Market
• (c) Long term loan market.
• Credit Market – A market where short-term and long-term loans are
granted to individuals or Organizations by various banks and Financial
and Non-Financial Institutions is called Credit Market.
• Money Market – Mostly dominated by Government, Banks and other
Large Institutions, the type of market is authorised for small-term
investments only. It is a wholesale debt market which works on low-risk
and highly liquid instruments. The money market can further be divided
into two types:
• (a) Organised Money Market
• (b) Unorganised Money Market
• Foreign exchange Market – One of the most developed markets across
the world, the Foreign exchange market, deals with the requirements
related to multi-currency. The transfer of funds in this market takes place
based on the foreign currency rate.
• Role of Indian financial system in economic
development of a country.
• 1. Savings-Investment Relationship :To attain economic
development, a country needs more investment and
production. This can happen only when there is a facility
for savings. The financial system mobilizes the savings of
the people by offering appropriate incentives and by
deepening and widening the financial structure. In other
words, the financial system creates varieties of forms of
savings so that savings can take place according to the
varying asset preferences of different classes of savers.
• 2. Encouraging Investments in Financial Assets :The
dynamic role of the financial system in the economic
development is that it encourages savings to flow into
financial assets (money and monetary assets) as against
physical assets (land, gold and other goods and
services). • The investments in physical assets are
speculative and would breed inflation. On the other
hand investments in financial assets are noninflationary
in nature and would aid growth in the economy. The
larger the proportion of the financial assets, the greater
is the scope for economic growth in the long run.
• 3- Infrastructure and Growth :Economic development of any
country depends on the infrastructure facility available in the
country. In the absence of key industries like coal, power and oil,
development of other industries will be hampered. It is here
that the financial services play a crucial role by providing funds
for the growth of infrastructure industries. Private sector will
find it difficult to raise the huge capital needed for setting up
infrastructure industries. For a long time, infrastructure
industries were started only by the government in India. But
now, with the policy of economic liberalization, more private
sector industries have come forward to start infrastructure
industry. The Development Banks and the Merchant banks help
in raising capital for these industries.
• 4- Employment Growth is Boosted : The presence of financial
system will generate more employment opportunities in the
country. The money market which is a part of financial system
provides working capital to the businessmen and
manufacturers due to which production increases, resulting in
generating more employment opportunities. With
competition picking up in various sectors, the service sector
such as sales, marketing, advertisement, etc., also pick up,
leading to more employment opportunities. Various financial
services such as leasing, factoring, merchant banking, etc.,
will also generate more employment. The growth of trade in
the country also induces employment opportunities.
• 5- Financial System Ensures Balanced Growth:
Economic development requires a balanced growth
which means growth in all the sectors
simultaneously. Primary sector, secondary sector
and tertiary sector require adequate funds for their
growth. The financial system in the country will be
geared up by the authorities in such a way that the
available funds will be distributed to all the sectors
in such a manner, that there will be a balanced
growth in industries, agriculture and service sectors.
• 6- Developing Backward Areas: The integral
policy of the national development plans of every
country concentrates on the development of
relatively less developed areas called backward
areas. The financial institutions provide a package
of services, infrastructure and incentives
conducive to a healthy growth of industries in
such backward areas and thus they contribute for
the uniform development of all regions in a
country.
 A BRIEF STUDY OF GOVERNMENT
INTERVENTION
• Government intervention is carried out by the government or public
entity that affects the market economy with the direct objective of
having an impact in the economy, beyond the mere regulation of
contracts and provision of public goods.
• Governments decided to remodel their financial systems, ostensibly to
ensure that (domestic) resources were allocated in accordance with
their development strategies. They nationalised existing financial
institutions, created new parastatals in an attempt to provide funding
at low interest rates to chosen (priority) sectors or they directed
existing institutions to comply with their instructions. To do so, banks
were directed to open rural branches to provide credit to widely
dispersed smallholders. Interest spreads imposed on financial
intermediaries were generally inadequate to cover higher transaction
costs.
Often, directed loans were net repaid. The inability, unwillingness and
disinclination of borrowers to repay their loans have become a serious
problem. Financial the countries have suffered heavy losses making them
insolvent.
Governments can take a number of actions to encourage the private
sector to take a greater role and participate in providing rural financial
services. The most important of these is a clear statement of government
policy with respect to informal financial systems, and the possibility of
entry by private sector investors in the formal financial sector.
The state also can assist by facilitating the exit of weak and inefficient
financial intermediaries. The first step therefore must be to develop clear
and policy objectives with regard to the development of the rural financial
the market in the country. The next step would be one of problem
identification to ease the constraints to financial market development.
 REGULATORY & PROMOTIONAL
INSTITUTIONS
• Viewed from a functional perspective, the government
institutions may be classified in three categories:
• 1) Regulatory Institutions: Regulatory Institutions to
ensure that firms provide the goods and services
promised and that their behaviours, in general, conform
to established standards in the country and/or abroad.
• 2) Promotional Institutions: Promotional Institutions that
are purposely established to create incentives and
facilities that motivate firms to engage in exporting.
• 3 ) Facilitatory Institutions: Facilitatory Institutions whose actions
directly or indirectly enhance the operational capabilities of firms.
• The two major Regulatory and Promotional institutions in India are:
• 1) Reserve Bank of India (RBI),
• 2) Securities Exchange Board of India (SEBI).
• Both RBI and SEBI administer, legislate, supervise, monitor, control and
discipline the entire financial system. RBI is the apex of all financial
institutions in India. All financial institutions are under the control of
RBI. The financial markets are under the control of SEBI.
• Both RBI and SEBI have laid down several policies, procedures and
guidelines. These policies, procedures and guidelines are changed
from time to time so as to set the financial system in the right
direction.
 The Reserve Bank of India (RBI)
• The Reserve Bank of India (RBI) is India’s central bank and
regulatory organisation in charge of banking regulation. It
belongs to the Indian government’s Ministry of Finance. The
Indian rupee is issued and distributed by it. It also oversees the
country’s major payment networks and aims to further the
country’s economic growth. The RBI’s Bharatiya Reserve Bank
Note Mudran division prints and mints Indian banknotes and
coins. To regulate India’s payment and settlement systems, the
RBI formed the National Payments Corporation of India as one of
its specialised divisions. The Reserve Bank of India formed the
Deposit Insurance and Credit Guarantee Corporation as a
specialised division to provide deposit insurance and credit
guarantee to all Indian banks.
• Establishment
• The Reserve Bank of India was established on April 1,
1935 in accordance with the provisions of the
Reserve Bank of India Act, 1934.
• The Central Office of the Reserve Bank was initially
established in Kolkata but was permanently moved to
Mumbai in 1937. The Central Office is where the
Governor sits and where policies are formulated.
• Though originally privately owned, since nationalisation
in 1949, the Reserve Bank is fully owned by the
Government of India.
• Role of Reserve Bank of India (RBI)
• It is in charge of deciding on the country’s monetary policy. The Reserve Bank of India’s
(RBI) primary responsibility is to preserve financial stability and appropriate liquidity in the
economy.
• Some of the significant functions of the Reserve Bank of India are mentioned and
explained below:
• Monetary Management – The formulation and seamless execution of monetary policy are
one of the Reserve Bank of India’s main responsibilities. Various policy instruments are
used by monetary policy to impact the cost and availability of money in the economy. The
goal remains to encourage economic growth while maintaining price stability. It assures a
steady supply of credit to the economy’s productive sectors.
• The issuer of Currency – Currency management and issuance are critical central banking
functions. The Reserve Bank of India (RBI) is in charge of the country’s currency design,
manufacture, distribution, and overall management. It aims to ensure that the state has a
sufficient supply of clean and legitimate notes. Its goal is to lower the risk of
counterfeiting. Counterfeit notes are frequently used for terrorist financing, which has a
variety of negative consequences.
• Banker and debt manager of the Government – The Reserve Bank of India
(RBI) is in charge of the government’s banking transactions. The Reserve Bank
of India also holds the cash holdings of the Indian government. It can also
serve as a lender to state governments. It appoints other banks to act as its
agents in carrying out the government’s transactions. On behalf of the federal
and state governments, it also manages public debt and offers new loans.
• Banker to Banks – The RBI is also responsible for the settlement of interbank
transactions. This is normally accomplished through the employment of a
“clearing house,” which allows banks to present cheques and other similar
instruments for clearing. The central bank serves as a common banker for all of
the banks.
• Financial Regulation and Supervision- The regulatory and supervisory powers
of the RBI are extensive. Through a variety of policy initiatives, it aims to
ensure general financial stability. Its goal is to ensure the orderly development
and conduct of banking activities, as well as bank liquidity and solvency.
• Developmental Role – The Reserve Bank of India (RBI) actively supports
and enhances development efforts in the country. It guarantees that
the productive sectors of the economy have access to sufficient credit
and establishes organisations to support the development of financial
infrastructure. It also tries to ensure that everyone has access to
banking services.
• Oversees Market Operations – The Central Bank implements its
monetary policy through government securities, foreign exchange, and
money market operations. It also regulates and develops market
instruments such as the term money market, repo market, and others.
• Foreign Exchange Management – The foreign exchange market is
regulated by the Reserve Bank of India (RBI). It has also opened
practically all areas to international investment.
 Functions Of RBI..
• Functions of RBI
• According to the RBI act 1934 RBI has various functions to serve. Some of them include:
• Monetary Authority: It plans and supervises the monetary policies designed for the country.
The objective behind this is that every policy should be designed keeping in mind the idea of
growth and at the same time should also maintain price stability.
• Financial System Supervisor: It designs the parameters under which all the banks of the
country should work. The main aim here is to maintain the trust of the general public in the
financial system of the country and provide them services which are cost-friendly.
• Foreign Exchange: All the foreign exchange that happens between the countries is
maintained and looked after by RBI. This is done so that easy and smooth foreign trade can
happen and also foreign market remains maintained.
• Issuer of currency: RBI is the authority who issues notes, destroys the old notes and decides
which currency is fit for circulation among the people. Demonitisation was done after taking
advice from RBI and the new notes of 2000 came into circulation.
• Development: various national projects are funded by RBI. It undertakes development of the
country as its objective and invests at various places in national interest.
 SEBI
• What is SEBI
• SEBI stands for Securities and Exchange Board
of India. It is a statutory regulatory body that
was established by the Government of India in
1992 for protecting the interests of investors
investing in securities along with regulating
the securities market. SEBI also regulates how
the stock market and mutual funds function.
• Objectives of SEBI
• Following are some of the objectives of the SEBI:
• 1. Investor Protection: This is one of the most important objectives
of setting up SEBI. It involves protecting the interests of investors by
providing guidance and ensuring that the investment done is safe.
• 2. Preventing the fraudulent practices and malpractices which are
related to trading and regulation of the activities of the stock
exchange
• 3. To develop a code of conduct for the financial intermediaries
such as underwriters, brokers, etc.
• 4. To maintain a balance between statutory regulations and self
regulation.
• Functions of SEBI
• SEBI has the following functions
• 1. Protective Function
• 2. Regulatory Function
• 3. Development Function
• The following functions will be discussed in detail
• Protective Function: The protective function implies the role that SEBI
plays in protecting the investor interest and also that of other financial
participants. The protective function includes the following activities.
• a. Prohibits insider trading: Insider trading is the act of buying or selling of
the securities by the insiders of a company, which includes the directors,
employees and promoters. To prevent such trading SEBI has barred the
companies to purchase their own shares from the secondary market.
• b. Check price rigging: Price rigging(occurs when parties conspire
to fix or inflate prices to achieve higher profits at the expense of
the consumer.) is the act of causing unnatural fluctuations in the
price of securities by either increasing or decreasing the market
price of the stocks that leads to unexpected losses for the
investors. SEBI maintains strict watch in order to prevent such
malpractices.
• c. Promoting fair practices: SEBI promotes fair trade practice and
works towards prohibiting fraudulent activities related to trading
of securities.
• d. Financial education provider: SEBI educates the investors by
conducting online and offline sessions that provide information
related to market insights and also on money management.
• Regulatory Function: Regulatory functions involve
establishment of rules and regulations for the financial
intermediaries along with corporates that helps in efficient
management of the market.
• The following are some of the regulatory functions.
• a. SEBI has defined the rules and regulations and formed
guidelines and code of conduct that should be followed by
the corporates as well as the financial intermediaries.
• b. Regulating the process of taking over of a company.
• c. Conducting inquiries and audit of stock exchanges.
• d. Regulates the working of stock brokers, merchant brokers.
• Developmental Function: Developmental function refers to
the steps taken by SEBI in order to provide the investors
with a knowledge of the trading and market function. The
following activities are included as part of developmental
function.
• 1. Training of intermediaries who are a part of the security
market.
• 2. Introduction of trading through electronic means or
through the internet by the help of registered stock brokers.
• 3. By making the underwriting an optional system in order to
reduce cost of issue.
• Purpose of SEBI
• The purpose for which SEBI was setup was to provide an
environment that paves the way for mobilsation and allocation
of resources. It provides practices, framework and
infrastructure to meet the growing demand.
• It meets the needs of the following groups:
• 1. Issuer: For issuers, SEBI provides a marketplace that can
utilised for raising funds.
• 2. Investors: It provides protection and supply of accurate
information that is maintained on a regular basis.
• 3. Intermediaries: It provides a competitive market for the
intermediaries by arranging for proper infrastructure.
• Structure of SEBI
• SEBI board comprises nine members. The Board consists
of the following members.
• One Chairman of the board who is appointed by the
Central Government of India
• One Board member who is appointed by the Central Bank,
that is, the RBI
• Two Board members who are hailing from the Union
Ministry of Finance
• Five Board members who are elected by the Central
Government of India.