Prepared by Kalyani Dutta

Financial System comprises , a set of sub-systems of financial institutions, financial markets, financial instruments and services which help in formation of capital. It provides a mechanism by which savings are transformed into investment.

The financial system is characterized by the presence of an 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.

“ A FINANCIAL SYSTEM MAY BE DEFINED AS A SET OF INSTITUTIONS, INSTRUMENTS AND MARKET WHICH FOSTER SAVINGS AND CHANNELS THEM TO MOST EFFICIENT USE. THE SYSTEM CONSISTS OF INDIVIDUALS ( SAVERS), INTERMEDIARIES, MARKET AND USERS OF SAVINGS”

_ H.R MACHIRAJU

DEFINITION

The word “system” means an ordered organisation & assemblage of facts , principles or components relating to particular field or for specified purpose.

A Financial System is an integral part of Modern Economy.

Functions:- Link between savers and investors. Selection of the projects to be financed and

review the performance of such projects. Payment mechanism for exchange of goods &

services Mechanism for the transfer of resources across

geographic boundaries. provide mechanism for Managing and control

risk Promotes capital formation by bringing

together the supply of savings & demand for investable funds.

Lowering the cost of transactions and

increase returns.Reduced cost motivate people to save more.

Provides information to the operators/ players in the market(indivisuals, govt,business houses.

Components and Constituents

Financial InstitutionsFinancial MarketsFinancial Instruments/Assets/Securities

Financial Services

Structure: Components of Indian Financial System

Financial Institutions Financial Markets Financial Instruments Financial Services

Banking Institutions

Non-Banking Institutions

Commercial Banks

Cooperative Banks

Public SectorPvt. SectorRRBsForeign Banks

DFIsa) Developments

Banks -All India - State Levelb)Invt Institutions (LIC,GIC,UTI)c) Specialized

Institution

Non-BankingFinancial Entitiesa) NBFCs - Equipment Leasing - Hire-Purchase - Investment - Loan

Money MarketCapital Market

-Call Money Market-Treasury Bills-Commercial Bills-Commercial Papers-CDs Primar

yMarket

SecondaryMarket

Term-Short term-Medium Term-Long Term

Type-PrimarySecurities-SecondarySecurities(Equity,Pref,Debt)-InnovativeInstruments

Asset/Fund Based-Leasing-Hire Purchase-Consumer Credit-Bill Discounting-Venture Capital-Housing Finance-Insurance-Factoring

Fee Based- Merchant Banking-Credit Rating-Stock Broking-Mergers

I. Financial Institutions

Financial institutions are the intermediaries who facilitate smooth functioning of the financial system by making investors and buyers meet.

Financial institutions mobilize saving of the surplus units & allocate them in productive activities promising a better rate of return.

Types of Financial Institutions:-

Banking Institutions Non-Banking Institutions

Banking Institutions

Indian banking industry is subject to the control of the Central Bank (RBI).Indian banking system can be classified in two categories.

1. Organized Sector 2. Unorganized Sector

a) Commercial Banksb) Co-operative Banksc) Regional Rural Banks (RRBs)d) Foreign Banks

Commercial Banks : Commercial banking system in India

consisted of 297 scheduled banks (including foreign banks) and one non-scheduled bank at the end of Dec. 2000.

Scheduled bankScheduled commercial Banks constitute those banks

which have been included in the Second Schedule of Reserve Bank of India(RBI) Act, 1934. RBI in turn includes only those banks in this schedule which satisfy the criteria laid down vide section 42 (60 of the Act.

"Non-scheduled bank in India" means a banking company as defined in clause (c) of section 5 of the Banking Regulation Act, 1949 (10 of 1949), which is not a scheduled bank".

Co-operative Banks : This segment is represented by a

group of societies registered under the Acts of the States relating to co-operative societies. These are classified into two broad categories:-

a) Rural credit societies which are primarily agricultural.

b) Urban credit societies which are primarily non-agricultural.

Regional Rural Banks (RRBs) : RRBs were set by the state government and the

sponsoring commercial banks with the objective of developing the rural economy. IDBI, NABARD (National bank for agriculture & rural development)and SIDBI are also required to provide managerial and financial assistance to RRBs under Regional Rural Bank Act.

Foreign Banks :1 Barclays Bank 2 Bank of Ceylon3 Bank Indonesia International4 Development Bank of Singapore5 Fuji Bank

Unorganised Sectora) Indigenous Bankers

b) Money Lenders (Seths and Sahukars)

Indigenous Bankers : Indigenous bankers are the forefathers of

modern commercial banks. As the term indigenous indicates, they are the local bankers.

Indigenous bankers provide finance for productive purposes directly to trade , industries,& indirectly through money lenders & traders to agriculture.

Money Lenders : Money lenders depend entirely on their own

funds for the working capital. Money lenders may be rural or urban, professional or non-professional. They enjoy monopoly in their areas of operation.

Money lenders are not bankers,their business is money lending only.

Characteristics of Money Lenders

1. Own funds.2. Weaker sections of the society.3. High rates of interest.4. Unregulated Operations5. Prompt and flexible.

Non-Banking Institutions

The non-banking institutions may be broadly categorised broadly into two groups:-

a) Organised Financial Institutionsb) Unorganised Financial Institutions

Organised Financial Institutions

1. Development Finance Institutions:- a) The institutions like IDBI, ICICI, IFCI(Industrial

finance cooperation of India), IIBI(industrial investment bank of india) at all India level.

b) State Finance Corporations (SFCs), State Industrial Development Corporations (SIDCs) at state level.

c) Agriculture Development Finance Institutions as NABARD etc.

. Investment Institutions :- It includes those financial institutions which mobilize savings of the public at large through various schemes and invest these funds in corporate and government securities. These include LIC, GIC,

UTI, and mutual funds.

Unorganised Financial Institutions The unorganised non-banking financial institutions

include number of non-banking financial companies (NBFCs) providing whole range of financial services.

Examples :

Hire-purchase and consumer finance companies, leasing companies, housing finance companies, factoring companies, credit rating agencies, merchant banking companies etc.

II. Financial Markets Financial markets refer to the institutional

arrangements for dealing in financial assets and credit instruments of different types such as currency, cheques, bank deposits, bills, bonds etc.

Classification :a) Negotiated loan market-is a market in which

lender & the borrower personally negotiate the terms of loan agreement.

b) Open Markets-in which standardized securities are traded in large volumes.-stock market

Functions of financial markets

1. Creation and allocation of credit and liquidity.

2. Intermediaries for mobilization of savings.3. Balanced economic growth.4. Financial convenience.5. Cater Credit needs of corporate houses.

Types of Financial Market

1) Money Market2) Capital Market

Money Market

Money Market refers to the institutional arrangements facilitating borrowing and lending of short-term funds.

The RBI describes money market as, “the centre for dealings, mainly of a short-term character, in monetary assets, it meets the short-term requirements of borrowers and provides liquidity or cash to the lenders.”

Money Market Instruments :

Commercial BillsTreasury BillsCall Money MarketCommercial PapersCertificate of Deposits

Commercial BillsIn the global money market, Commercial

Paper is an unsecured promissory note with a fixed maturity of 1 to 270 days. Commercial Paper is a money-market security issued (sold) by large banks and corporations to get money to meet short term debt obligations .

Treasury Bills

Just like commercial bills which represent commercial debt, treasury bills represent short-term borrowings of the Government. Treasury bill market refers to the market where treasury bills are brought and sold. Treasury bills are very popular and enjoy higher degree of liquidity since they are issued by the government.

Call money marketMarket in which brokers and dealers borrow

money to satisfy their credit needs, either to finance their own inventory of securities .

Commercial papers. promissory note (issued by financial

institutions or large firms) with very-short to short maturity period (usually, 2 to 30 days, and not more than 270 days), and secured only by the reputation of the issuer. Rated, bought, sold, and traded like other negotiable instruments, commercial paper is a popular means of raising cash,

Certificate of Deposit

A savings certificate entitling the bearer to receive interest. A CD bears a maturity date, a specified fixed interest rate and can be issued in any denomination. CDs are generally issued by commercial banks . The term of a CD generally ranges from one month to five years.

Functions of the Money Market

1. Adjustment of liquidity position of commercial banks.

2. Provides short-term funds 3. Short-term funds to the government

institutions.4. Helpful to businessmen 5. Proper flow of funds.6. Provide outlets to various borrowers such

as businessman, traders, Industrialists. 7. Mechanism for credit control.

Capital Market The term ‘capital market’ refers to the

institutional arrangements for facilitating the borrowing and lending of long-term funds.

Repo is a collateralized lending i.e. the banks which borrow money from Reserve Bank to meet short term needs have to sell securities

Capital Market Instruments :

Equity SharesPreference SharesDebentures

Importance of Capital Market

a) Coordination and balance between savings and investment.

b) Optimum utilisation of financial resources.c) Concentration of national savings d) To maintain the Expected rate of economic

growth

III. Financial Instruments

A financial instrument/asset/security is a claim, against a person or an institution, for the payment of a sum of money or a periodic payment in the form of interest or dividend, at a specified future date.

Types of Financial Securities

1. PRIMARY SECURITIES –direct securites,issued directly by borrower of funds.

2. SECONDARY SECURITIES –indirect securities eg –Insurance & mutual funds.

Some new innovative financial instruments :i. Equity Warrantsii. Secured Premium notesiii. Regular Income Bondsiv. Retirement Bondsv. Inflation Adjusted Bondsvi. Easy Exit Bondvii. Growth Bonds

IV. FINANCIAL SERVICES

Financial services are the activities, benefits and satisfactions, connected with the sale of money, that offer to users and customers, financial related value .

Suppliers of Financial Services

i) Banks and Financial Institutionsii) House Building Societiesiii) Insurance Companiesiv) Credit Card Issuer Companiesv) Investment Trusts and Mutual Fundsvi) Stock Exchangesvii) Leasing Companies/Equipment

Finance/Consumer Finance Companiesviii) Unit Trusts

Characteristics of Financial Services1. Intangible2. Direct Sale3. Heterogeneity4. Fluctuation in demand5. Protect Consumer’s interest6. Labour Intensive7. Geographical dispersion8. Lack of special identity9. Information based10. Require quality labour

Kinds of Financial Services

A. Asset based/fund based services.

B. Fee based/advisory services

Asset/Fund Based Services

1. Equipment Leasing/Lease Financing2. Hire Purchase and Consumer Credit3. Bill Discounting4. Venture Capital5. Housing Finance6. Insurance Services7. Factoring

Equipment leasing Leasing is an arrangement that provides a

firm with the use & control over assets without buying them.it is the form of renting assests.

Hire purchaseHire purchase means transaction where

goods are purchased & sold on the terms that payment will be made in instalments.the possession of the goods given to buyer.The ownership right remains with the vendor

till the last instalment is paid.The seller can repossess the goods in case of

default in payment of any instalment.

Bill discountingAccording to negotiable instrument act 1881 The bill of exchange is an instrument in

writing containing an unconditional order,signed by maker ,directing a certain person to pay a certain sum of money only to,or to order of,a certain person,or to the bearer of that instrument.

Venture capitalThe term venture capital represents financial

investment in a highly risky project with the objective of earning high rate of return.

Housing financeHousing finance emerged as a fund based

financial service in the country with the setting up of national housing bank by RBI IN 1998.

INSURANCE SERVICESWith setting up of the IRDA Act 1999,the

monopoly of LIC & GIC has been dismantled & new players entered in the field.

FactoringA factor is a financial institution which offers

services related to management & financing of Debts.

B. Fee Based Advisory Services

1. Merchant Banking 2. Credit Rating3. Stock Broking

Indian Financial System-An Overview

Before Independence After Independence till 1990 After 1990

Stage I : Before Independence

Characteristics :

Unorgainsed system Few industrial securities in securities

market No separate issuing institution Outside savings were restricted.

Stage II : After Independence (1948-90)

1) Transfer of Ownership from Private to Public Sector:

a) Nationalization of RBI b) Setting up of State Bank of India c) Nationalization of Life Insurance Business d) Nationalization of Commercial Banks e) Nationalization of General Insurance

Business.

2. Setting up of Financial Institutions

a) Development of Finance Institutions : IFCI, SFC’s, NIDC, ICICI, LIC, IDBI etc.b) Investing Institutions : UTI established in

1964, LIC in 1956, GIC in 1973.c) Other Institutions : RCI in 1971, EXIM Bank in

1982, NABARD in 1982.

STAGE III : After 1990’s

a) Privatization in banking and insurance sector. b) Development of Finance Institutions c) Emergence of Non-Banking Financial

Companiesd) Growth of Mutual Funds.e) Establishment of SEBI Act in 1992.