Indian Financial System-Bharati Pathak

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11/01/2016 ContentsTheIndianFinancialSystem:Markets,InstitutionsandServices,3rdEdition

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ContentsPreface

PartIFinancialSystem

1TheFinancialSystem:AnIntroduction

Introduction

FormalandInformalFinancialSectors

TheIndianFinancialSystem

ComponentsoftheFormalFinancialSystem

FinancialInstitutions

FinancialMarkets

FinancialInstruments

FinancialServices

InteractionAmongFinancialSystemComponents

FunctionsofaFinancialSystem

KeyElementsofaWellFunctioningFinancialSystem

FinancialSystemDesigns

NatureandRoleofFinancialInstitutions(Intermediaries)andFinancialMarkets

FinancialMarkets

MoneyMarketandCapitalMarket

PrimaryCapitalMarketandSecondaryCapitalMarket

CharacteristicsofFinancialMarkets

FunctionsofFinancialMarkets

KeyTerms

Summary

ReviewQuestions

References

2TheFinancialSystemandtheEconomy

Introduction

TypesofEconomicUnits

AMacroeconomicFrameworkAnalysisforExploringtheRoleoftheFinancialSystemintheEconomy

NationalIncomeAccounts

ClassificationoftheIndianEconomy

FlowofFundsAccounts

PREVTitle Page

NEXTDedication

The Indian Financial System: Markets, Institutions and Services, 3rd Edition



FlowofFundsbasedIndicatorsofFinancialDevelopment

TrendsinSavingandInvestment

WhyStudySavingandInvestment

SavingandInvestmentinIndia

HouseholdSectorFinancialSaving

SavingandInvestmentintheLongRun

Conclusion

RelationshipBetweentheFinancialSystemandEconomicGrowth:SomeTheoreticalandEmpiricalEvidence

EmpiricalResearchEvidenceonRelationshipBetweentheFinancialSystemandEconomicGrowth

KeyTerms

Summary

ReviewQuestions

References

3ReformsintheFinancialSystem

Background

IndianFinancialSysteminthePrereformsPeriod

ObjectivesofFinancialSystemReforms

FinancialEfficiency,Stability,andIntegration

Conclusion

KeyTerms

Summary

ReviewQuestions

References

PartIIFinancialMarkets

4TheMoneyMarket

Introduction

FunctionsoftheMoneyMarket

BenefitsofanEfficientMoneyMarket

TheIndianMoneyMarket

RoleoftheReserveBankofIndiaintheMoneyMarket

StepstoDeveloptheMoneyMarketinIndia

MoneyMarketCentres

MoneyMarketInstruments

TreasuryBills

FeaturesofTBills

TypesofTBills

ImportanceofTBills

DevelopmentoftheTBillsMarket

ParticipantsintheTBillsMarket

SaleofTBills

TypesofAuctions

91DayTBills

Sizeofthe91DayTBillsMarket

CompetitiveBidsandNoncompetitiveBids

364DayTBills




182DayTBills

14DayTBills


ImplicitYieldatCutoffPrices

Conclusion

CommercialPaper

TheProcessforIssuingaCP

GuidelinesRelatingtoCPs

SummaryofGuidelinesforIssuanceofaCP

StampDutyonCP

SizeoftheCPMarket

SecondaryMarketinCPs

FactorsInhibitingtheGrowthoftheCPMarket

CommercialPaper:AComparativePosition

CommercialBills

TypesofCommercialBills

FeaturesofCommercialBills

MeasurestoDeveloptheBillsMarket

SizeoftheCommercialBillsMarket

CertificatesofDeposit

MeasurestoDeveloptheCDMarket

GuidelinesforIssueofCertificatesofDeposit(CDs)

SecondaryMarketforCDs

SizeoftheCDMarket

FactorsInhibitingtheGrowthofCDs

ComparisonofCertificatesofDepositandCommercialPapers

Call/NoticeMoneyMarket

Introduction

WhyCallMoney

ParticipantsintheCallMoneyMarket

ReportingofCall/NoticeMoneyTransactions

RoleoftheReserveBankintheCallMoneyMarket

LinkBetweentheCallMoneyMarketandOtherFinancialMarkets

CallRate

MIBOR

CallRatesVolatility

FactorsInfluencingCallMoneyMarketRate

MeasuresforCurbingHighVolatility

StepstoConverttheCallMoneyMarketintoaPureInterbankMarket

TermMoneyMarket

CollateralisedBorrowingandLendingObligation(CBLO)

LinkBetweentheMoneyMarketandtheMonetaryPolicyinIndia

ToolsforManagingLiquidityintheMoneyMarket

ReserveRequirements

InterestRates

BankRate

RefinancefromtheReserveBank

Repos

MoneyMarketDerivatives



InterestRateSwap

PlainVanillaInterestRateSwaps

ApplicationsofInterestRateSwaps

ForwardRateAgreements

PlainVanillaForwardRateAgreements

ParticipantsintheIRS/FRAMarket

GuidelinesRelatingtoIRSs/FRAs

IntroductionofNewDerivativeInstruments

AnOverviewoftheMoneyMarket

KeyTerms

Summary

ReviewQuestions

References

5TheCapitalMarket

Introduction

FunctionsofaCapitalMarket

PrimaryCapitalMarketandSecondaryCapitalMarket

HistoryoftheIndianCapitalMarket

ABriefHistoryoftheRiseofEquityTradinginIndia

CapitalMarketScams

Introduction

The199192SecuritiesScam(TheHarshadMehtaScam)

The2001Scam(KetanParekhScam)

ComparisonoftheHarshadMehtaScamandtheKetanParekhScam

Conclusion

ReformsintheCapitalMarket

ThePrimaryCapitalMarket

SecondaryCapitalMarket

KeyTerms

Summary

ReviewQuestions

References

6ThePrimaryMarket

Introduction

IntermediariestoanIssue

FreePricingRegime

BookBuildingANewIssueMechanisminIndia

TheBookBuildingProcess

BiddingProcess

DeterminationofPrice

RegisteringofProspectuswithRegistrarofCompanies

ApplicationsSupportedbyBlockedAmount(ASBA)Process

Allotment/AllocationinBookBuiltIssue

AnchorInvestor

BenefitsofBookBuildingMethod

LimitationsoftheBookBuildingMethod

AuctionbasedBookBuilding

ReverseBookBuilding

Conclusion



GreenShoeOption

OnLineIPOs

PrimaryIssues

PublicIssue

RightsIssue

IndianDepositoryReceipts(IDRs)

PrivatePlacementMarket

PreferentialIssue

QualifiedInstitutionsPlacement(QIP)

ResourceMobilisationfromthePrimaryMarket

NongovernmentPublicLimitedCompanies(PrivateSector)

MegaIssuesFloatedbyNongovernmentPublicLimitedCompanies

AbsorptionofPrivateCapitalIssues

BanksandFinancialInstitutionsinthePublicSector

MutualFunds

ResourceMobilisationfromInternationalMarkets

FactorsLeadingtoanIncreaseinthePopularityofInternationalMarkets

GlobalDepositoryReceipts(GDRs)

AmericanDepositoryReceipts(ADRs)

OrganisingEuroIssues

GuidelinesRelatingtoInternationalIssues

ResourcesRaisedthroughEuroIssues

ExternalCommercialBorrowings(ECBs)

ForeignCurrencyConvertibleBonds(FCCBs)

ForeignCurrencyExchangeableBonds(FCEBs)

EnduseofFCEBProceeds

IssuingCompany

PromoterGroupCompanies

ParkingofFCEBProceedsAbroad

Conclusion

KeyTerms

Summary

ReviewQuestions

References

7DisinvestmentofPublicSectorUndertakings

Introduction

Disinvestment

DisinvestmentMachinery

ThePSUSelloffMethods

StrategicSalesTechniques

ProceedsRealisedfromDisinvestment

PSUDisinvestment:SummaryofReceiptsfromDisinvestment:199192to3092009

EvaluatingtheDisinvestmentProgramme

DisinvestmentofPSUsinDifferentCountries

Conclusion

KeyTerms

Summary



ReviewQuestions

References

8TheSecondaryMarket

Introduction

FunctionsoftheSecondaryMarket

DevelopmentoftheStockMarketinIndia

PostreformsMarketScenario

RegulationofStockExchanges

Organisation,ManagementandMembershipofStockExchanges

DemutualisationofStockExchanges

ListingofSecurities

CentralListingAuthority

TheSEBI(CentralListingAuthority)Regulations,2003

RiskManagement

TradingRulesandRegulations

CircuitBreakers

TradingArrangements

TradingandSettlement

DematerialisationofSecurities

InternetTrading

StockMarketIndex

MethodologiesforCalculatingtheIndex

GlobalStockMarketIndices

MajorIndicesinIndia

StockExchanges

TheBombayStockExchange

BSEMilestones

CarryForwardDeals,orBadla

BadlaMechanism

Advantages

ListingCategories

BSEIndices

TrendsinTurnoverontheBSE

Conclusion

TheNationalStockExchangeofIndia

MembershipPatternontheNSE

Indices

NationalSecuritiesClearingCorporationLimited

MarginRequirements

CapitalMarketSegmentoftheNSE

Conclusion

TheOvertheCounterExchangeofIndia(OTCEI)

TradingDocumentsontheOTCEI

AdvantagesofOTCEI

StepstoImproveTurnoverontheOTCEI

Conclusion

TheInterConnectedStockExchangeofIndiaLtd

RegionalStockExchanges

INDONEXT



MeasurestoBoostLiquidityintheSecondaryMarket

InvestmentbyForeignInstitutionalInvestorsintheIndianStockMarket

Depositories

BuyBackofShares

Conclusion

MarketMakingSystem

StockLendingandBorrowing(SLB)

Conclusion

RollingSettlement

RollingSettlement

Conclusion

StraightthroughProcessing(STP)

MarginTrading

Conclusion

ImpactofReformsandMeasuresonSecondaryMarketActivities

Conclusion

KeyTerms

Summary

ReviewQuestions

References

9TheDerivativesMarket

Introduction

EconomicBenefitsofDerivatives

DerivativesDefinedundertheSecuritiesContracts(Regulation)Act,1956

HistoryofDerivativesTrading

TypesofFinancialDerivatives

DistinctiveFeaturesoftheDerivativesMarket

ExchangetradedversusOTCDerivativesMarkets

TradersinDerivativesMarket

ForwardsandFutures

ForwardContracts

FuturesContracts

NeedforFuturesMarkets

FuturesTerminology

RoleofClearingHouse/Corporation

PricingFutures

FuturesTradingStrategies

HedgingwithIndexFutures

StrategiesforSpeculation

ArbitrageStrategies

Options

TypesofOptions

SalientFeaturesofOptions

MarginsApplicableonOptions

OptionsTerminology

ComparingFuturesandOptions

BenefitsofOptions



PayoffProfileofCallOptions

PayoffProfileofPutOptions

PricingOptions

AssumptionsUnderlyingtheBlackScholesOptionPricingModel

OptionsTradingStrategies

OptionSpreads

VolatilityTrading

ArbitragewithOptions

HedgingwithOptions

DerivativesMarketinIndia

DerivativesMarketattheNSE

DerivativesTradinginIndia

StockIndexOptions

Conclusion

KeyTerms

Summary

ReviewQuestions

References

10TheDebtMarket

Introduction

HistoryoftheIndianDebtMarket

LinkBetweentheMoneyMarketandtheDebtMarket

CharacteristicsoftheDebtMarket

ParticipantsintheDebtMarket

TypesofInstrumentsTradedintheDebtMarket

DematerialisationofDebtSecurities

PrimaryandSecondarySegmentsofDebtMarket

ThePrivateCorporateDebtMarket

RegulatoryAgenciesResponsibleforRegulatingDifferentSegmentsoftheCorporateDebtMarket

RegulationsonIssueandListingofDebtSecurities

ThePrimaryMarketforCorporateDebt

TheSecondaryMarketforCorporateDebt

SEBIRegulationsRelatingtoTradingofDebtSecurities

MeasurestoPromotetheCorporateDebtMarket

ThePublicSectorUndertakingBondMarket

SecondaryMarketinPSUBonds

TheGovernmentSecuritiesMarket

Introduction

ImportanceoftheGovernmentSecuritiesMarket(GSM)

Issuers,Investors,andTypesofGovernmentSecurities

GovernmentSecuritiesMarketinthePre1991Period

ObjectivesofReformsintheGovernmentSecuritiesMarket

SomePolicyMeasuresUndertakeninthe1990s

STRIPSintheGovernmentSecuritiesMarket

RetailingofGovernmentSecurities

WhenissuedMarketinGovernmentSecurities

TheSystemofWaysandMeansAdvances(WMA)fortheCentre

WhatisWaysandMeansAdvances?



AdvantagesofWMA

WMALimits

PrimaryandSecondaryMarketSegmentsoftheGovernmentSecuritiesMarket

GovernmentDatedSecurities

OwnershipPatternofCentralandStateGovernmentSecurities

ToolsforManagingLiquidityintheGovernmentSecuritiesMarket

InfrastructureDevelopmentoftheGovernmentSecuritiesMarket

Conclusion

MeasurestoStrengthentheGovernmentSecuritiesMarketInfrastructure

ImpactofReformsintheGovernmentSecuritiesMarket

RelativeSizeofFinancialMarketsinIndia

Conclusion

KeyTerms

Summary

ReviewQuestions

References

11NewFinancialInstruments

Introduction

WhatisaNewFinancialInstrument?

ReasonsforInnovationsinFinancialInstruments

NewFinancialInstruments

FloatingRateBonds

ZeroInterestBonds

DeepDiscountBonds(DDBs)

RevolvingUnderwritingFinanceFacility(RUFF)

AuctionRatedDebentures(ARDs)

SecuredPremiumNotes(SPNs)withDetachableWarrants

NonconvertibleDebentures(NCDs)withDetachableEquityWarrants

SecuredZeroInterestPartlyConvertibleDebentureswithDetachableandSeparatelyTradableWarrants

FullyConvertibleDebentures(FCDs)withInterest(Optional)

DomesticConvertibleBonds

DifferentialShares

SecuritisedPaper

CollateralisedDebtObligations(CDO)

InverseFloatBonds

PerpetualBonds

MunicipalBonds

Conclusion

KeyTerms

Summary

ReviewQuestions

References

PartIIIFinancialInstitutions

12DevelopmentFinancialInstitutions

Introduction

EvolutionofDevelopmentBanks



DevelopmentFinancialInstitutionsinIndia

ChangingRoleofDevelopmentFinancialInstitutions

UniversalBanking

PolicyMeasuresRelatingtoDevelopmentFinancialInstitutions

PolicyMeasures

IndustrialFinanceCorporationofIndiaLimited

FinancingActivities

DevelopmentalandPromotionalActivitiesofIFCI

StepsTakenforRevival

Conclusion

TheSmallIndustriesDevelopmentBankofIndia

FinancialProductsOfferedbySIDBI

Subsidiaries

ResourcesRaisedbySIDBI

Conclusion

InfrastructureDevelopmentFinanceCompanyLimited

CapitalisationofIDFC

SubsidiaryCompanies

InstitutionalPositioningofIDFC

IDFC'sOperations

Conclusion

TheExportImportBankofIndia

Objectives

EximBankBusinessProfile

PerformanceandContribution

Conclusion

NationalBankforAgricultureandRuralDevelopment

NABARD'sMission

FunctionsofNABARD

PromotionandDevelopment

Refinance

Credit

DirectCredit

RuralInfrastructureDevelopmentFund

ThrustAreasofNABARD

ParticipationinNewVentures

AmendmentstotheNABARDAct,1981

NABARDasaConsultant

NABARDasaSupervisor

InstitutionalDevelopment

Conclusion

KeyTerms

Summary

ReviewQuestions

References

13BankingandNonBankingInstitutions

BankingInstitutions

FunctionsofBank

Deposits



CreditCreation

LendingofFunds

AncilliaryFunctions

RegulationofBanksinIndia

DevelopmentofBankinginIndia

ScheduledCommercialBanks

PublicSectorBanks

NationalisedBanks

PrivateSectorBanks

ForeignBanksinIndia

BranchesofIndianBanksAbroad

SettingupofOffshoreBankingUnits

Mobilisation,LendingandInvestmentofFunds

InvestmentsofBanks

InvestmentsinSLRSecurities

InvestmentsinNonSLRSecurities

ReformsintheBankingSector

BankingSectorReforms

CapitalAdequacy

AssetQuality

SystemsandMethods

IndustryStructure

RegulationandSupervision

LegalAmendments

TechnologyinBanking

PaymentandSettlementSystem

DiversificationinBankOperations

ConsolidationinBanking

EquityCapitalRaisedbyPublicSectorBanks

RiskManagementinBanks

StepsinRiskManagementProcess

RiskManagementTools

AssetLiabilityManagement(ALM)

ALMGuidelines

StressTesting

GuidelinesforStressTesting

RemedialActions

PrudentialRegulation

RegulatoryCapitalandEconomicCapital

TheBaselCapitalAccord

ImplementationofBaselNormsinIndia

Pillar1

Pillar2

Pillar3

CapitalAdequacyNorms

RBIGuidelinesonCapitalAdequacy

ElementsofTier1Capital

ElementsofTier2Capital

CapitalChargeforCreditRisk



CapitalChargeforMarketRisk

GeneralMarketRisk

MeasurementofCapitalChargeforEquityRisk

MeasurementofCapitalChargeforForeignExchangeRisk

CapitalChargeforOperationalRisk

Example

Solution

ComputationofRiskWeightedAssets

RiskWeightedAssetsforCreditRisk

RiskWeightedAssetsforMarketRisk(TradingBook)

RegionalRuralBanks

LocalAreaBanks

Conclusion

CooperativeBanking

UrbanCooperativeBanks

SupervisionandInspectionofUCBs

InvestmentsinNonSLRSecuritiesbyUCBs

PlacementofDepositswithOtherBanksbyUCBs

ClassificationofCapitalFunds

AssetClassificationandProvisioningNorms

GuidelinesforMergerofUCBs(HavingNegativeNetWorth)withDICGCSupport

RuralCooperativeBanks

Conclusion

NonbankingFinancialCompanies

TypesofNBFCs

GrowthofNBFCs

RegulationofNBFCs

OverviewofRegulationofNBFCs

RegulatoryNormsandDirectionsforNBFCs

A.ImportantStatutoryProvisionsofChapterIIIBoftheRBIActasApplicabletoNBFCs

B.DirectionsApplicabletoNBFCs

Supervision

RoleofBoardforFinancialSupervisioninMonitoringNBFCs

Conclusion

KeyTerms

Summary

ReviewQuestions

14ManagementofNonPerformingAssetsbyBanks

Introduction

ToolsAvailabletoBankstoManagetheirNPAS

OneTimeSettlement/CompromiseScheme

LokAdalats

DebtRecoveryTribunals

CorporateDebtRestructuring(CDR)

WillfulDefaulters

SARFAESIAct

AssetReconstructionCompanies



CIBIL

Conclusion

KeyTerms

Summary

ReviewQuestions

Annexure14.1PrudentialNormsonIncomeRecognition,AssetClassification,andProvisioningpertainingtoAdvances

15MutualFunds

Introduction

BenefitsofMutualFunds

HistoryofMutualFunds

GrowthofMutualFundsinIndia

MutualFundConcepts

MutualFundInvestorsandOrganisationofaMutualFund

Sponsor

MutualFundsasTrusts

AssetManagementCompany

OtherAdministrativeEntities

RoleofIntermediariesintheIndianMutualFundIndustry

TypesofMutualFundSchemes

FunctionalClassificationofMutualFunds

PortfolioClassification

InvestmentClassification

GeographicalClassification

EquityFunds

DiversifiedEquityFunds

ValueFunds

SpecialFunds

SectoralFunds

DerivativesArbitrageFunds

TaxSavingSchemes

FundofFunds

QuantFunds

DebtFunds

OtherFunds

RiskandReturninMutualFunds

ReturnsfromMutualFunds

EquityorientedSchemes

DebtorientedSchemes

HowtoInvestinaSchemeofMutualFund?

SEBIGuidelinesRelatingtoMutualFunds

MutualFundSchemes

InvestmentObjective

PricingofUnits

InvestmentbySchemes

DisclosureRequirements

ReportingRequirement

ExistingSchemes

OtherAspects



OverseasInvestmentsbyMutualFunds

TheAssociationofMutualFundsinIndia

ObjectivesofAMFI

UnitTrustofIndia

UTI'sAssociates

PromotionofInstitutions

US64

GrowthandPerformanceofMutualFundsinIndia

Conclusion

16Insurance

Introduction

RoleofInsuranceinEconomicGrowth

PrinciplesofInsurance

OriginandDevelopmentofInsurance

HistoryofInsuranceinIndia

OpeningoftheInsuranceSector

InsuranceRegulatoryandDevelopmentAuthority

InsuranceRegulatoryandDevelopmentAuthority

MissionStatementoftheIRDA

Duties,Powers,andFunctionsoftheIRDA

OperationsoftheIRDA

PolicyHolder'sGrievancesRedressalSystem

PolicyHolder'sGrievancesRedressalSystem

BusinesstobeDonebyanInsurerintheRuralSector

RuralandSocialSectorObligationsforNewEntrants

InsuranceIntermediaries

Agents

SurveyorsandLossAssessors

Brokers

ThirdPartyAdministrators

Bancassurance

RiskManagement

GeneralInsurance

GeneralInsuranceProducts

DevelopmentofGeneralInsurance

TariffAdvisoryCommitee

DetariffinginNonlifeInsurance

GeneralInsuranceCouncil

PatternofInvestments

ApprovedInvestmentsforGeneralBusiness

Exposure/PrudentialNorms

RuralandSocialSectorObligationsforNewEntrants

MaintenanceofSolvencyMarginsofGeneralInsurers

NonlifeInsuranceIndustry

Conclusion

HealthInsurance

HealthInsurancePolicies

Conclusion

Reinsurance



TypesofReinsurance

ReinsuranceBusinessinLifeandGeneralInsurance

LifeInsuranceReinsuranceRegulations,2000

NonlifeReinsuranceRegulations

GeneralInsuranceCorporationofIndia

OperationsofGIC

Conclusion

LifeInsurance

BenefitsofLifeInsurance

LifeInsuranceProducts

NewPlayersintheLifeInsuranceMarket

ChangingTrendsinLifeInsurance

Investments

MaintenanceofSolvencyMarginsofInsurers

LifeInsuranceCouncil

LifeInsuranceCorporation(LIC)ofIndia

LICSubsidiaries

LICProducts

AchievementsofLIC

TheLifeInsuranceIndustry

MicroInsurance

MicroInsuranceDistribution

MicroInsuranceRegulation

FutureofMicroInsurance

Conclusion

KeyTerms

ReviewQuestions

PartIVFinancialServices

17InvestmentBanking

Introduction

FunctionsofInvestmentBanks

TypesofInvestmentBanks

InvestmentbankingServices

(I)FundraisingServices

(II)AdvisoryServices

MerchantbankingServices

SEBI(MerchantBanker)Regulations,1992

AppointmentofLeadMerchantBankers

ResponsibilitiesofLeadManagers

AcquisitionofSharesProhibited

InformationtotheBoard

DisclosurestotheSEBI

AppointmentofComplianceOfficer

PreissueObligations

DocumentstobeSubmittedAlongwiththeOfferDocumentbytheLeadManager

Undertaking

ListofPromoters'GroupandOtherDetails



AppointmentofIntermediaries

AppointmentofOtherIntermediaries

Underwriting

OfferDocumenttobeMadePublic

NocomplaintCertificate

MandatorycollectionCentres

AuthorisedCollectionAgents

AbridgedProspectus

AgreementswithDepositories

PostissueObligations

PostissueMonitoringReports

RedressalofInvestorGrievances

CoordinationwithIntermediaries

Underwriters

BankerstoanIssue

PostissueAdvertisements

BasisofAllotment

ProportionateallotmentProcedure

OtherResponsibilities

ChangingLandscapeofInvestmentBanking

KeyTerms

Summary

ReviewQuestions

References

18DepositoriesandCustodians

TheDepositorySystem

NeedforSettingupaDepositoryinIndia

DifferenceBetweenaDematShareandaPhysicalShare

BenefitsofaDepositorySystem

CostComparisonforTradinginPhysicalandDematSegments

TheMoveontoaDepositorySysteminIndia

TheDepositoryProcess

Trading/SettlementofDematSecurities

TheNationalSecuritiesDepositoryLimited

BusinessPartnersoftheNSDL

TheCentralDepositoryServices(India)Limited

ComparisonofChargesattheNSDLandtheCDSLandGrowthofDematAccounts

GrowthinDematAccounts

Custodians

TheStockHoldingCorporationofIndiaLimited

NewProductsIntroducedbytheSHCIL

KeyTerms

Summary

ReviewQuestions

References

19CreditRating

Introduction

TheImportanceofCreditRating



OriginoftheConceptofCreditRating

TheGrowthoftheCreditRatingIndustryinIndia

RatingMethodology

RatingSymbols

SEBIRegulationsforCreditRatingAgencies

RatingProcess

DefaultStudies

DealingwithConflictofInterest

ObligationsinRespectofRatingofStructuredFinanceProducts

UnsolicitedCreditRatings

Disclosures

Shareholding

ComplianceStatusofIOSCOCodeofConduct

CreditRatingAgenciesinIndia

CRISILLimited(FormerlytheCreditRatingInformationServicesofIndiaLimited)

ICRALimited(FormerlyInvestmentInformationandCreditRatingAgencyofIndiaLimited)

CreditAnalysisandResearchLimited(CARE)Ratings

FitchRatingsIndiaPrivateLimited

BrickworkRatings

RatingAgenciesforSMEs

IPOGradingbyCreditRatingAgencies

LimitationsofCreditRatinginIndia

Conclusion

KeyTerms

Summary

ReviewQuestions

References

20FactoringandForfaiting

Introduction

Factoring

TheOriginofFactoring

TypesofFactoring

FactoringMechanism

FactoringCharges

LegalAspectsofFactoring

AdvantagesofFactoring

ComparisonofFactoringwithBillsDiscountingandCashCredit

InternationalFactoring

InternationalFactoringCharges

FactorChainInternational

FactoringinIndia

FactorsInhibitingtheGrowthofFactoringinIndia

Forfaiting

OriginofForfaiting

CharacteristicsofaForfaitingTransaction

NeedforForfaiting

BenefitsofForfaiting



FlowChartofaForfaitingTransaction

PricingofaForfaitingTransaction

DifferenceBetweenForfaitingandFactoring

GrowthofForfaitinginIndia

Conclusion

KeyTerms

Summary

ReviewQuestions

References

21HousingFinance

Introduction

RoleofHousingandHousingFinanceintheEconomy

EvolutionofHousingandHousingFinanceinIndia

PolicyInitiativesandMeasurestoDevelopHousingSectorinIndia

HousingfinanceInstitutions(HFIS)

ScheduledCommercialBanks(SCBs)

ScheduledCooperativeBanks

RegionalRuralBanks(RRBs)

AgricultureandRuralDevelopmentBanks(ARDBs)

HousingfinanceCompanies(HFCs)

TheNationalCooperativeHousingFederationofIndia(NCHF)

ApexcooperativeHousingfinanceSocieties(ACHFS)

TypesofHousingLoans

RiskManagementByHFCs

MarketingStrategiesofHFCs

NationalHousingBank

RoleofNHBinHousingFinance

VariousInitiativesUndertakenbyNHBfortheDevelopmentofHousinginIndia

PrudentialNormsfortheHousingfinanceSector

ResidentialMortgagebackedSecuritisation

BenefitsofSecuritisation

ReversemortgageLoan(RML)

BenefitsofRML

HousingfinanceIndustry:IssuesandFutureOutlook

KeyTerms

Summary

ReviewQuestions

References

22LeasingandHirePurchase

IntroductiontoLeaseFinancing

LeasingandEconomicGrowth

LeasinginIndia

LeaseStructure

Rights,ObligationsandResponsibilitiesoftheLessor

Rights,ObligationsandResponsibilitiesoftheLessee

TypesofLeases

AdvantagesandDisadvantagesofLeasing

AccountingforLeaseintheBookofLessee



AccountingforLeaseintheBookofLessor

LegalAspectofLeasing

TaxationAspectofLeasing

HirePurchase

EssentialsofHirePurchase

DifferenceBetweenLeaseandHirePurchase

AccountingforHirePurchase

LegalAspectsofHirePurchase

TaxationAspectofHirePurchase

InstalmentPurchase

DifferenceBetweenInstalmentPurchaseandHirePurchase

Conclusion

KeyTerms

Summary

ReviewQuestions

References

23FinancialInclusionandMicrofinance

IntroductiontoFinancialInclusion

EvidencesofFinancialExclusion

BenefitsofFinancialInclusion

ProcessofFinancialInclusion

VariousInitiativesUndertakenforFinancialInclusion

Conclusion

Microfinance

Microfinance:TheParadigm

NGOsandSHGs

MicrofinanceDeliveryMechanisms

ResourcesforSupportingMicrofinance

MicrofinanceDevelopmentFund(MFDF)

CollaborationwithExternalAgencies

TheMicroFinancialSector(DevelopmentandRegulations)Bill,2007

ThePositiveSideofMicrofinance

TheDownsideofMicrofinance

FutureofMicrofinance

KeyTerms

Summary

ReviewQuestions

References

PartVFinancialRegulation

24FinancialRegulation

RegulationoftheCapitalMarket

TheSecuritiesandExchangeBoardofIndia(SEBI)

ManagementoftheSEBIundertheSEBIAct,1992

PowersandFunctionsoftheSEBI

Regulations,Guidelines,andSchemesIssuedbytheSEBI

RegulationoftheSecuritiesMarket

SupervisionofSecuritiesMarket

InspectionofMutualFunds




SelfRegulatoryOrganisations(SROs)

InvestorProtectionMeasures

Investors'Education

Investors'GrievancesRedressal

Investors'Associations

AchievementsoftheSEBI

FuturePlans

Conclusion

TheReserveBankofIndia

ObjectivesoftheReserveBank

OrganisationoftheReserveBank

Subsidiaries

LegalFramework

MainFunctionsoftheRBI

RoleoftheReserveBankofIndia

Conclusion

KeyTerms

Summary

ReviewQuestions

References


Chapter 20:Analysis ofHumanResource inIndia over

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1

The Financial System: An Introduction

Chapter Objectives

Thischapterwillenableyoutodevelopanunderstandingofthefollowing:

1. Meaningofafinancialsystem

2. Componentsofafinancialsystem

3. Functionsofafinancialsystem

4. Keyelementsofawellfunctioningfinancialsystem

5. Bankbasedandmarketbasedfinancialsystems

6. Natureandroleoffinancialinstitutionsandfinancialmarkets

7. Linkbetweenmoneymarketsandcapitalmarkets

8. Linkbetweenprimarymarketsandsecondarymarkets

9. Functionsandcharacteristicsoffinancialmarkets

INTRODUCTION

Afinancialsystemplaysavitalroleintheeconomicgrowthofacountry.Itintermediatesbetweentheflowoffundsbelongingtothosewhosaveapartoftheirincomeandthosewhoinvestinproductiveassets.Itmobilisesandusefullyallocatesscarceresourcesofacountry.

Afinancialsystemisacomplex,wellintegratedsetofsubsystemsoffinancialinstitutions,markets,instruments,andserviceswhichfacilitatesthetransferandallocationoffunds,efficientlyandeffectively.

Formal and Informal Financial Sectors

Thefinancialsystemsofmostdevelopingcountriesarecharacterisedbycoexistenceandcooperationbetweentheformalandinformalfinancialsectors.Thiscoexistenceofthesetwosectorsiscommonlyreferredtoasfinancialdualism.Theformalfinancialsectorischaracterisedbythepresenceofanorganised,institutional,andregulatedsystemwhichcaterstothefinancialneedsofthemodernspheresofeconomytheinformalfinancialsectorisanunorganised,noninstitutional,andnonregulatedsystemdealingwiththetraditionalandruralspheresoftheeconomy.

Theinformalfinancialsectorhasemergedasaresultoftheintrinsicdualismofeconomicandsocialstructuresindevelopingcountries,andfinancialrepressionwhichinhibitsthecertaindeprivedsectionsofsocietyfromaccessingfunds.Theinformalsystemischaracterisedbyflexibilityofoperationsandinterfacerelationshipsbetweenthecreditorandthedebtor.Theadvantagesare:lowtransactioncosts,minimaldefaultrisk,andtransparencyofprocedures.Duetotheseadvantages,awiderangeandhigherratesofinterestprevailintheinformalsector.

Aninterpenetrationisfoundbetweentheformalandinformalsystemsintermsofoperations,participants,andnatureofactivitieswhich,in

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turn,haveledtotheircoexistence.Ahighpriorityshouldbeaccordedtothedevelopmentofanefficientformalfinancialsystemasitcanofferlowerintermediationcostsandservicestoawidebaseofsaversandentrepreneurs.

The Indian Financial System

TheIndianfinancialsystemcanalsobebroadlyclassifiedintotheformal(organised)financialsystemandtheinformal(unorganised)financialsystem.TheformalfinancialsystemcomesunderthepurviewoftheMinistryofFinance(MoF),theReserveBankofIndia(RBI),theSecuritiesandExchangeBoardofIndia(SEBI),andotherregulatorybodies.Theinformalfinancialsystemconsistsof:

InformalFinancialSystem

Advantages

Lowtransactioncosts

Minimumdefaultrisk

Transparencyofprocedures

Disadvantages

Widerangeofinterestrates

Higherratesofinterest

Unregulated

Individualmoneylenderssuchasneighbours,relatives,landlords,traders,andstoreowners.

Groupsofpersonsoperatingasfundsorassociations.Thesegroupsfunctionunderasystemoftheirownrulesandusenamessuchasfixedfund,association,andsavingclub.

Partnershipfirmsconsistingoflocalbrokers,pawnbrokers,andnonbankfinancialintermediariessuchasfinance,investment,andchitfundcompanies.

InIndia,thespreadofbankinginruralareashashelpedinenlargingthescopeoftheformalfinancialsystem.

COMPONENTS OF THE FORMAL FINANCIAL SYSTEM

Theformalfinancialsystemconsistsoffoursegmentsorcomponents.Theseare:financialinstitutions,financialmarkets,financialinstruments,andfinancialservices(referFigure1.1).

ClassificationofFinancialInstitutions

Bankingandnonbanking

Termfinance

Specialised

Sectoral

Investment

Statelevel

Financial Institutions

Theseareintermediariesthatmobilisesavingsandfacilitatetheallocationoffundsinanefficientmanner.

Financialinstitutionscanbeclassifiedasbankingandnonbankingfinancialinstitutions.Bankinginstitutionsarecreatorsandpurveyorsofcreditwhilenonbankingfinancialinstitutionsarepurveyorsofcredit.Whiletheliabilitiesofbanksarepartofthemoneysupply,thismaynotbetrueofnonbankingfinancialinstitutions.InIndia,nonbankingfinancialinstitutions,namely,thedevelopmentalfinancialinstitutions(DFIs),andnonbankingfinancialcompanies(NBFCs)aswellashousingfinancecompanies(HFCs)arethemajorinstitutionalpurveyorsofcredit.

FinancialinstitutionscanalsobeclassifiedastermfinanceinstitutionssuchastheIndustrialDevelopmentBankofIndia(IDBI),theIndustrialCreditandInvestmentCorporationofIndia(ICICI),theIndustrialFinancialCorporationofIndia(IFCI),theSmallIndustriesDevelopment




BankofIndia(SIDBI),andtheIndustrialInvestmentBankofIndia(IIBI).

FinancialinstitutionscanbespecialisedfinanceinstitutionsliketheExportImportBankofIndia(EXIM),theTourismFinanceCorporationofIndia(TFCI),ICICIVenture,theInfrastructureDevelopmentFinanceCompany(IDFC),andsectoralfinancialinstitutionssuchastheNationalBankforAgriculturalandRuralDevelopment(NABARD)andtheNationalHousingBank(NHB).

InvestmentinstitutionsinthebusinessofmutualfundsUnitTrustofIndia(UTI),publicsectorandprivatesectormutualfundsandinsuranceactivityofLifeInsuranceCorporation(LIC),GeneralInsuranceCorporation(GIC)anditssubsidiariesareclassifiedasfinancialinstitutions.

TherearestatelevelfinancialinstitutionssuchastheStateFinancialCorporations(SFCs)andStateIndustrialDevelopmentCorporations(SIDCs)whichareownedandmanagedbytheStategovernments.

Inthepostreformsera,theroleandnatureofactivityofthesefinancialinstitutionshaveundergoneatremendouschange.Bankshavenowundertakennonbankactivitiesandfinancialinstitutionshavetakenupbankingfunctions.Mostofthefinancialinstitutionsnowresorttofinancialmarketsforraisingfunds.

Financial Markets

Financialmarketsareamechanismenablingparticipantstodealinfinancialclaims.Themarketsalsoprovideafacilityinwhichtheirdemandsandrequirementsinteracttosetapriceforsuchclaims.

Types

Moneymarket

Capitalmarket

Segments

Primarymarket

Secondarymarket

ThemainorganisedfinancialmarketsinIndiaarethemoneymarketandthecapitalmarket.Thefirstisamarketforshorttermsecuritieswhilethesecondisamarketforlongtermsecurities,i.e.,securitieshavingamaturityperiodofoneyearormore.

Financialmarketscanalsobeclassifiedasprimaryandsecondarymarkets.Whiletheprimarymarketdealswithnewissues,thesecondarymarketismeantfortradinginoutstandingorexistingsecurities.Therearetwocomponentsofthesecondarymarket:overthecounter(OTC)marketandtheexchangetradedmarket.ThegovernmentsecuritiesmarketisanOTCmarket.InanOTCmarket,spottradesarenegotiatedandtradedforimmediatedeliveryandpaymentwhileintheexchangetradedmarket,tradingtakesplaceoveratradingcycleinstockexchanges.Recently,thederivativesmarket(exchangetraded)hascomeintoexistence.

Financial Instruments

Afinancialinstrumentisaclaimagainstapersonoraninstitutionforpayment,atafuturedate,ofasumofmoneyand/oraperiodicpaymentintheformofinterestordividend.Thetermand/orimpliesthateitherofthepaymentswillbesufficientbutbothofthemmaybepromised.Financialinstrumentsrepresentpaperwealthshares,debentures,likebondsandnotes.Manyfinancialinstrumentsaremarketableastheyaredenominatedinsmallamountsandtradedinorganisedmarkets.Thisdistinctfeatureoffinancialinstrumentshasenabledpeopletoholdaportfolioofdifferentfinancialassetswhich,inturn,helpsinreducingrisk.Differenttypesoffinancialinstrumentscanbedesignedtosuittheriskandreturnpreferencesofdifferentclassesofinvestors.



Figure1.1IndianFinancialSystem

TypesofFinancialSecurities

Primary

Secondary

DistinctFeatures

Marketable

Tradeable

Tailormade

Savingsandinvestmentsarelinkedthroughawidevarietyofcomplexfinancialinstrumentsknownassecurities.SecuritiesaredefinedintheSecuritiesContractsRegulationAct(SCRA),1956asincludingshares,scrips,stocks,bonds,debentures,debenturestocksorothermarketablesecuritiesofasimilarnatureorofanyincorporatedcompanyorbodycorporate,governmentsecurities,derivativesofsecurities,unitsofcollectiveinvestmentscheme,securityreceipts,interestandrightsinsecurities,oranyotherinstrumentssodeclaredbythecentralgovernment.

Financialsecuritiesarefinancialinstrumentsthatarenegotiableandtradeable.Financialsecuritiesmaybeprimaryorsecondarysecurities.Primarysecuritiesarealsotermedasdirectsecuritiesastheyaredirectlyissuedbytheultimateborrowersoffundstotheultimatesavers.Examplesofprimaryordirectsecuritiesincludeequitysharesanddebentures.Secondarysecuritiesarealsoreferredtoasindirectsecurities,astheyareissuedbythefinancialintermediariestotheultimatesavers.Bankdeposits,mutualfundunits,andinsurancepoliciesaresecondarysecurities.

Financialinstrumentsdifferintermsofmarketability,liquidity,reversibility,typeofoptions,return,risk,andtransactioncosts.Financialinstrumentshelpfinancialmarketsandfinancialintermediariestoperformtheimportantroleofchannelisingfundsfromlenderstoborrowers.Availabilityofdifferentvarietiesoffinancialinstrumentshelpsfinancialintermediariestoimprovetheirownriskmanagement.

NeedofFinancialServicesfor

Borrowingandfunding

Lendingandinvesting

Buyingandsellingsecurities

Makingandenabling

Paymentsandsettlements

Managingrisk

Financial Services

Thesearethosethathelpwithborrowingandfunding,lendingandinvesting,buyingandsellingsecurities,makingandenablingpaymentsandsettlements,andmanagingriskexposuresinfinancialmarkets.Themajorcategoriesoffinancialservicesarefundsintermediation,



paymentsmechanism,provisionofliquidity,riskmanagement,andfinancialengineering.

Fundsintermediatingserviceslinkthesaverandborrowerwhich,inturn,leadstocapitalformation.Newchannelsoffinancialintermediationhavecomeintoexistenceasaresultofinformationtechnology.Paymentservicesenablequick,safe,andconvenienttransferoffundsandsettlementoftransactions.

Liquidityisessentialforthesmoothfunctioningofafinancialsystem.Financialliquidityoffinancialclaimsisenhancedthroughtradinginsecurities.Liquidityisprovidedbybrokerswhoactasdealersbyassistingsellersandbuyersandalsobymarketmakerswhoprovidebuyandsellquotes.

Financialservicesarenecessaryforthemanagementofriskintheincreasinglycomplexglobaleconomy.Theyenablerisktransferandprotectionfromrisk.Riskcanbedefinedasachanceofloss.Risktransferofserviceshelpthefinancialmarketparticipantstomoveunwantedriskstootherswhowillacceptit.Thespeculatorswhotakeontheriskneedatradingplatformtotransferthisrisktootherspeculators.Inaddition,marketparticipantsneedfinancialinsurancetoprotectthemselvesfromvarioustypesofriskssuchasinterestratefluctuationsandexchangeraterisk.

Growingcompetitionandadvancesincommunicationandtechnologyhaveforcedfirmstolookforinnovativewaysforvaluecreation.Financialengineeringpresentsopportunitiesforvaluecreation.Theseservicesrefertotheprocessofdesigning,developing,andimplementinginnovativesolutionsforuniqueneedsinfunding,investing,andriskmanagement.Restructuringofassetsand/orliabilities,offbalancesheetitems,developmentofsyntheticsecurities,andrepackagingoffinancialclaimsaresomeexamplesoffinancialengineering.

Theproducersofthesefinancialservicesarefinancialintermediaries,suchas,banks,insurancecompanies,mutualfunds,andstockexchanges.Financialintermediariesprovidekeyfinancialservicessuchasmerchantbanking,leasing,hirepurchase,andcreditrating.Financialservicesrenderedbythefinancialintermediariesbridgethegapbetweenlackofknowledgeonthepartofinvestorsandtheincreasingsophisticationoffinancialinstrumentsandmarkets.Thesefinancialservicesarevitalforcreationoffirms,industrialexpansion,andeconomicgrowth.

Beforeinvestorslendmoney,theyneedtobereassuredthatitissafetoexchangesecuritiesforfunds.Thefinancialregulatorwhoregulatestheconductofthemarketandintermediariestoprotecttheinvestors'interestsprovidesthisreassurance.Theregulatorregulatestheconductofissuersofsecuritiesandtheintermediariestoprotecttheinterestsofinvestorsinsecuritiesandincreasestheirconfidenceinmarketswhich,inturn,helpsinthegrowthanddevelopmentofthefinancialsystem.Regulationisnecessarynotonlytodevelopasystem,butasystemoncedevelopedneedstoberegulated.TheRBIregulatesthemoneymarketandtheSEBIregulatesthecapitalmarket.ThesecuritiesmarketisregulatedbytheDepartmentofEconomicAffairs(DEA),theDepartmentofCompanyAffairs(DCA),theRBI,andtheSEBI.Ahighlevelcommitteeoncapitalandfinancialmarketscoordinatestheactivitiesoftheseagencies.

InteractionAmongtheComponents

Interdependent

Interactive

Closelinks

Competingwitheachother

Interaction Among Financial System Components

Thefourfinancialsystemcomponentsdiscusseddonotfunctioninisolation.Theyareinterdependentandinteractcontinuouslywitheachother.Theirinteractionleadstothedevelopmentofasmoothlyfunctioningfinancialsystem.

Financialinstitutionsorintermediariesmobilisesavingsbyissuingdifferenttypesoffinancialinstrumentswhicharetradedinthefinancialmarkets.Tofacilitatethecreditallocationprocess,theseinstitutionsacquirespecialisationandrenderspecialisedfinancialservices.

Financialintermediarieshavecloselinkswiththefinancialmarketsintheeconomy.Financialinstitutionsacquire,hold,andtradefinancialsecuritieswhichnotonlyhelpinthecreditallocationprocessbutalsomakethefinancialmarketslarger,moreliquid,stable,anddiversified.Financialintermediariesrelyonfinancialmarketstoraisefunds



whenevertheneedarises.Thisincreasesthecompetitionbetweenfinancialmarketsandfinancialintermediariesforattractinginvestorsandborrowers.Thedevelopmentofnewsophisticatedmarketshasledtothedevelopmentofcomplexsecuritiesandportfolios.Theevaluationofthesecomplexsecurities,portfolios,andstrategiesrequiresfinancialexpertisewhichfinancialintermediariesprovidethroughfinancialservices.

Financialmarketshavealsomadeanimpactonthefunctioningoffinancialintermediariessuchasbanksandfinancialinstitutions.Thelatterare,today,radicallychangedentitiesasthebulkoftheservicefeesandnoninterestincomethattheyderiveisdirectlyorindirectlylinkedtofinancialmarketrelatedactivities.

Moreover,liquidandbroadmarketsmakefinancialinstrumentsamoreattractiveavenueforsavings,andfinancialservicesmayencouragefurthersavingsifthenetreturnstoinvestorsareraisedorincreased.

FunctionsofaFinancialSystem

Mobiliseandallocatesavings

Monitorcorporateperformance

Providepaymentandsettlementsystems

Optimumallocationofriskbearingandreduction

Disseminatepricerelatedinformation

Offerportfolioadjustmentfacility

Lowerthecostoftransactions

Promotetheprocessoffinancialdeepeningandbroadening

FUNCTIONS OF A FINANCIAL SYSTEM

Oneoftheimportantfunctionsofafinancialsystemistolinkthesaversandinvestorsand,thereby,helpinmobilisingandallocatingthesavingsefficientlyandeffectively.Byactingasanefficientconduitforallocationofresources,itpermitscontinuousupgradationoftechnologiesforpromotinggrowthonasustainedbasis.

Afinancialsystemnotonlyhelpsinselectingprojectstobefundedbutalsoinspirestheoperatorstomonitortheperformanceoftheinvestment.Financialmarketsandinstitutionshelptomonitorcorporateperformanceandexertcorporatecontrolthroughthethreatofhostiletakeoversforunderperformingfirms.

Itprovidesapaymentmechanismfortheexchangeofgoodsandservicesandtransferseconomicresourcesthroughtimeandacrossgeographicregionsandindustries.Paymentandsettlementsystemsplayanimportantroletoensurethatfundsmovesafely,quickly,andinatimelymanner.Anefficientpaymentandsettlementsystemcontributestotheoperatingandallocationefficienciesofthefinancialsystemandthus,overalleconomicgrowth.Paymentandsettlementsystemsserveanimportantroleintheeconomyasthemainarteriesofthefinancialsector.Banksprovidethismechanismbyofferingameansofpaymentfacilitybaseduponcheques,promissorynotes,creditanddebitcards.Thispaymentmechanismisnowincreasinglythroughelectronicmeans.Theclearingandsettlementsmechanismofthestockmarketsisdonethroughdepositoriesandclearingcorporations.

Oneofthemostimportantfunctionsofafinancialsystemistoachieveoptimumallocationofriskbearing.Itlimits,pools,andtradestherisksinvolvedinmobilisingsavingsandallocatingcredit.Anefficientfinancialsystemaimsatcontainingriskwithinacceptablelimits.Itreducesriskbylayingdownrulesgoverningtheoperationofthesystem.Riskreductionisachievedbyholdingdiversifiedportfoliosandscreeningofborrowers.Marketparticipantsgainprotectionfromunexpectedlossesbybuyingfinancialinsuranceservices.Riskistradedinthefinancialmarketsthroughfinancialinstrumentssuchasderivatives.Derivativesareriskshiftingdevices,theyshiftriskfromthosewhohaveitbutmaynotwantittothosewhoarewillingtotakeit.

Afinancialsystemalsomakesavailablepricerelatedinformationwhichisavaluableassistancetothosewhoneedtotakeeconomicandfinancialdecisions.Financialmarketsdisseminateinformationforenablingparticipantstodevelopaninformedopinionaboutinvestment,disinvestment,reinvestment,orholdingaparticularasset.Thisinformationdisseminationenablesaquickvaluationoffinancialassets.Moreover,byinfluencingthemarketpriceofafirm'sdebtandequityinstruments,thisprocessofvaluationguidesthemanagementastowhethertheiractionsareconsistentwiththeobjectiveofshareholderwealthmaximisation.Inaddition,afinancialsystemalsominimisessituationswheretheinformationisasymmetricandlikelytoaffect



motivationsamongoperatorswhenonepartyhastheinformationandtheotherpartydoesnot.Italsoreducesthecostofgatheringandanalysinginformationtoassistoperatorsintakingdecisionscarefully.

Afinancialsystemalsooffersportfolioadjustmentfacilities.Theseareprovidedbyfinancialmarketsandfinancialintermediariessuchasbanksandmutualfunds.Portfolioadjustmentfacilitiesincludeservicesofprovidingaquick,cheapandreliablewayofbuyingandsellingawidevarietyoffinancialassets.

Afinancialsystemhelpsinthecreationofafinancialstructurethatlowersthecostoftransactions.Thishasabeneficialinfluenceontherateofreturntosavers.Italsoreducesthecostofborrowing.Thus,thesystemgeneratesanimpulseamongthepeopletosavemore.

Awellfunctioningfinancialsystemhelpsinpromotingtheprocessoffinancialdeepeningandbroadening.FinancialdeepeningreferstoanincreaseoffinancialassetsasapercentageoftheGrossDomesticProduct(GDP).Financialdepthisanimportantmeasureoffinancialsystemdevelopmentasitmeasuresthesizeofthefinancialintermediarysector.Depthequalstheliquidliabilitiesofthefinancialsystem(currencyplusdemandandinterestbearingliabilitiesofbanksandnonbankfinancialintermediariesdividedbytheGDP).Financialbroadeningreferstobuildinganincreasingnumberandvarietyofparticipantsandinstruments.

BasicElementsofaWellfunctioningFinancialSystem

Astronglegalandregulatoryenvironment

Stablemoney

Soundpublicfinancesandpublicdebtmanagement

Acentralbank

Soundbankingsystem

Informationsystem

Wellfunctioningsecuritiesmarket

KEY ELEMENTS OF A WELL-FUNCTIONING FINANCIAL SYSTEM

Thebasicelementsofawellfunctioningfinancialsystemare(i)astronglegalandregulatoryenvironment,(ii)stablemoney,(iii)soundpublicfinancesandpublicdebtmanagement,(iv)acentralbank,(v)asoundbankingsystem,(vi)aninformationsystem,and(vii)awellfunctioningsecuritiesmarket.

Sincefinanceisbasedoncontracts,stronglegalandregulatorysystemsthatproduceandstrictlyenforcelawsalonecanprotecttherightsandinterestsofinvestors.Hence,astronglegalsystemisthemostfundamentalelementofasoundfinancialsystem.

Stablemoneyisanimportantconstituentasitservesasamediumofexchange,astoreofvalue(areserveoffuturepurchasingpower),andastandardofvalue(unitofaccount)forallthegoodsandserviceswemightwishtotradein.Largefluctuationsanddepreciationinthevalueofmoneyleadtofinancialcrisesandimpedethegrowthoftheeconomy.

Soundpublicfinanceincludessettingandcontrollingpublicexpenditureprioritiesandraisingrevenuesadequatetofundthemefficiently.Historically,thesefinancingneedsofthegovernmentsworldoverledtothecreationoffinancialsystems.Developedcountrieshavesoundpublicfinancesandpublicdebtmanagementpractices,whichresultinthedevelopmentofagoodfinancialsystem.

Acentralbanksupervisesandregulatestheoperationsofthebankingsystem.Itactsasabankertothebanks,bankertothegovernment,managerofpublicdebtandforeignexchange,andlenderofthelastresort.Themonetarypolicyofthecentralbankinfluencesthepaceofeconomicgrowth.Anautonomouscentralbankpavesthewayforthedevelopmentofasoundfinancialsystem.

Agoodfinancialsystemmustalsohaveavarietyofbanksbothwithdomesticandinternationaloperationstogetherwithanabilitytowithstandadverseshockswithoutfailing.Banksarethecorefinancialintermediariesinallcountries.Theyperformdiversekeyfunctionssuchasoperatingtheclearingandpaymentssystem,andtheforeignexchangemarket.Thebankingsystemisthemainfulcrumfortransmittingthemonetarypolicyactions.Banksalsoundertakecreditriskanalysis,assessingtheexpectedriskandreturnontheprojects.Thefinancialsoundnessofthebankingsystemdependsonhoweffectivelybanksperformthesediversefunctions.



Anotherfoundationalelementisinformation.Alltheparticipantsinafinancialsystemrequireinformation.Asoundfinancialsystemcandeveloponlywhenproperdisclosurepracticesandnetworkingofinformationsystemsareadopted.

Securitiesmarketsfacilitatetheissueandtradingofsecurities,bothequityanddebt.Efficientsecuritiesmarketspromoteeconomicgrowthbymobilisinganddeployingfundsintoproductiveuses,loweringthecostofcapitalforfirms,enhancingliquidity,andattractingforeigninvestment.Anefficientsecuritiesmarketstrengthensmarketdisciplinebyexertingcorporatecontrolthroughthethreatofhostiletakeoversforunderperformingfirms.

FinancialSystemDesigns

Bankbased

Marketbased

FINANCIAL SYSTEM DESIGNS

Afinancialsystemisaverticalarrangementofawellintegratedchainoffinancialmarketsandinstitutionsthatprovidefinancialintermediation.Differentdesignsoffinancialsystemsarefoundindifferentcountries.Thestructureoftheeconomy,itspatternofevolution,andpolitical,technical,andculturaldifferencesaffectthedesign(type)offinancialsystem.

Twoprominentpolardesignscanbeidentifiedamongthevarietythatexists.Atoneextremeisthebankdominatedsystem,suchasinGermany,whereafewlargebanksplayadominantroleandthestockmarketisnotimportant.Attheotherextremeisthemarketdominatedfinancialsystem,asintheUS,wherefinancialmarketsplayanimportantrolewhilethebankingindustryismuchlessconcentrated.Theothermajorindustrialcountriesfallinbetweenthesetwoextremes(Figure1.2).

Source:AllenandGale(2000),ComparingFinancialSystems,MITPress,Cambridge,Mass.

Figure1.2OverviewandTradeoffsofFinancialSystems

DemirgucKuntandLevine(1999)haveprovidedexplanationsofbankbasedandmarketbasedfinancialsystems.Inbankbasedfinancialsystems,banksplayapivotalroleinmobilisingsavings,allocatingcapital,overseeingtheinvestmentdecisionsofcorporatemanagers,andprovidingriskmanagementfacilities.Inmarketbasedfinancialsystems,thesecuritiesmarketssharecentrestagewithbanksinmobilisingthesociety'ssavingsforfirms,exertingcorporatecontrol,andeasingriskmanagement.

Bankbasedsystemstendtobestrongerincountrieswheregovernmentshaveadirecthandinindustrialdevelopment.InIndia,bankshavetraditionallybeenthedominantentitiesoffinancialintermediation.Thenationalisationofbanks,anadministeredinterestrateregime,andthegovernmentpolicyoffavouringbanksledtothepredominanceofabankbasedfinancialsystem.

DemirgucKuntandLevine,usingadatabaseof150countries,haveclassifiedcountriesaccordingtothestructureandleveloffinancialdevelopment(Table1.1).

TABLE1.1ClassificationofFinancialStructureandLevelofDevelopmentofSelectEconomies



Extentof

Development

Bankbased Marketbased

Developed Japan,Germany,France,Italy

US,UK,Singapore,Malaysia,Korea

Underdeveloped Argentina,Pakistan,SriLanka,Bangladesh

Brazil,Mexico,thePhilippines,Turkey

Source:DemirgucKunt,A.andR.Levine(1999),BankbasedandMarketbasedFinancialSystem:CrossCountryComparisons,WorldBankPolicyResearchWorkingPaperNo.2143.

Theircomparisonoffinancialsystemsacrossdifferentincomegroupsrevealsseveralpatterns.First,financialsystemsare,onanaverage,moredevelopedinrichcountries.Thereisatendencyforafinancialsystemtobecomemoremarketorientedasthecountrybecomesricher.Second,countrieswithacommonlawtradition,strongprotectionofshareholders'rights,andlowlevelsofcorruptiontendtobemoremarketbasedandhavewelldevelopedfinancialsystems.

ArnoldandWalz(2000)haveattemptedtoidentifyfactorsleadingtotheemergenceofbankbasedormarketbasedfinancialsystems.Whenproblemsrelatingtoinformationpersistbutbanksarecompetentenoughrightfromthebeginningand,withthepassageoftime,learnthroughexperiencetobecomemoreproductive,theycometodominatethefinancialsystem.Conversely,ifbanksareinitiallyincompetentandfailtoimprovethemselvesbyexperience,thebankbasedsystemgiveswaytothegrowthofamarketbasedfinancialsystem.

MarketbasedFinancialSystem

Advantages

Providesattractivetermstobothinvestorsandborrowers

Facilitatesdiversification

Allowsrisksharing

Allowsfinancingofnewtechnologies

Drawbacks

Pronetoinstability

Exposuretomarketrisk

Freeriderproblem

Giventhesetwotypesoffinancialsystems,questionsariseabouttheadvantagesanddisadvantagesofabankbasedfinancialsystemvisavisamarketbasedfinancialsystem.Someresearcherssuggestthatmarketsaremoreeffectiveatprovidingfinancialserviceswhilesometouttheadvantagesofintermediaries.

Proponentsofthemarketbasedviewarguethatefficiencyisassociatedwiththefunctioningofcompetitivemarkets.Financialmarketsareattractiveastheyprovidethebesttermstobothinvestorsandborrowers.Stockmarketsfacilitatediversificationandallowefficientrisksharing.Theyprovideincentivestogatherinformationthatisreflectedinstockpricesandtheseprices,inturn,providesignalsforanefficientallocationofinvestment.Animportantareainwhichfinancialmarketsperformdifferentlyfromfinancialintermediariesisinsituationswhereadiversityofopinionisimportant,suchasthefinancingofnewtechnologiesorwhenanunusualdecisionhastobemade.Hence,inemergingindustrieswithsignificantfinancialandtechnologicalrisks,amarketbasedsystemmaybepreferable.

Thedrawbacksofthemarketbasedsystemarethatitismorepronetoinstability,itsinvestorsareexposedtomarketrisks,andthatthereisafreeriderproblem.Thelastdrawbackariseswhennoindividualiswillingtocontributetowardsthecostofsomethingbuthopesthatsomeoneelsewillbearthecost.Thisproblemariseswheneverthereisapublicgoodandseparationofownershipfromcontrol.Forexample,shareholderstakelittleinterestinthemanagementoftheircompanies,hopingsomeoneelsewillmonitortheexecutives.Inamarketbasedsystem,thefreeriderproblembluntstheincentivestogatherinformation.

Ontheotherhand,abankbasedsystemisperceivedtobemorestable,astherelationshipwithpartiesisrelativelyclose.Thisleadstotheformationoftailormadecontractsandfinancialproductsandefficientintertemporalrisksharing.Financialintermediariescaneliminatethe



risksthatcannotbediversifiedatagivenpointoftimebutcanbeaveragedovertimethroughintertemporalsmoothingofassetreturns.Thisrequiresthatinvestorsacceptlowerreturnsthanwhatthemarketoffersinsomeperiodsinordertogethigherreturnsinotherperiods.Thisprovidesaninsurancetoinvestorswhowouldotherwisebeforcedtoliquidateassetsatdisadvantageousprices.

Thebankingsystemavoidssomeoftheinformationdeficienciesassociatedwiththesecuritiesmarkets.Thefreeriderproblemiseliminatedasprivateincentivestogatherinformationarehigherinthecaseofabankbasedsystem.Moreover,bankscanperformscreeningandmonitoringfunctionsonbehalfoftheinvestorsthesefunctions,lefttothemselves,canbeundertakenonlyatahighcost.

BankbasedFinancialSystem

Advantages

Closerelationshipwithparties

Providestailormadecontracts

Efficientintertemporalrisksharing

Nofreeriderproblem

Drawbacks

Retardsinnovationandgrowth

Impedescompetition

Thegreatestdrawbackofabankbasedsystemisthatitretardsinnovationandgrowthasbankshaveaninherentpreferenceforlowrisk,lowreturnprojects.Moreover,powerfulbanksmaycolludewithfirmmanagersagainstotherinvestors,which,insomecases,couldimpedecompetition,effectivecorporatecontrol,andentryofnewfirms.

Thecurrenttrendisapreferenceforthemarketbasedsystem.FranceandJapanhavereformedtheirmarketstomakethemmorecompetitive.Itispartlyduetothegrowingvolumeofbankingactivityinthefinancialmarkets.TheEuropeanUnionismovingtowardsasingleunifiedmarkettoincreaseitsglobalcompetitiveness.InIndiaalso,theroleofstockmarketshasgainedprominence.Thegovernmenthasputinsubstantialeffortstoreformthefinancialmarkets.TheIndianequitymarket,now,isatparwithsomeofthedevelopedmarketsoftheworld.Moreover,theratioofmarketcapitalisationtoassetsofscheduledcommercialbankshasrisensharplyfrom28.4percentinMarch1991to79.3percentinMarch2000.Therelativeshareofbanksintheaggregatefinancialassetsofbanksandfinancialinstitutionstakentogether,whichstoodatnearlythreefourthsintheearly1980s,isnowhoveringaroundthetwothirdsmarksincethe1990s.Thisimpliesthatthereisconsiderablepotentialforgrowthinmarketfinancing.

Box 1.1 Evolution of Financial Systems

Inthe1950sand1960s,GurleyandShaw(1955,1960,1967)andGoldsmith(1969)discussedthestagesintheevolutionoffinancialsystems.Accordingtothem,thereisalinkbetweenpercapitaincomeandthedevelopmentofafinancialsystem.Atlowlevelsofdevelopment,mostinvestmentisselffinancedandfinancialintermediariesdonotexist,asthecostsoffinancialintermediationarehighrelativetobenefits.Ascountriesdevelopandpercapitaincomeincreases,bilateralborrowingandlendingtakeplaceleadingtothebirthoffinancialintermediaries.Thenumberoffinancialintermediariesgrowswithfurtherincreasesinpercapitaincome.Amongthefinancialintermediaries,bankstendtobecomelargerandprominentinfinancialinvestment.Ascountriesexpandeconomically,nonbankfinancialintermediariesandstockmarketsgrowinsizeandtendtobecomemoreactiveandefficientrelativetobanks.Thereisageneraltendencyforfinancialsystemstobecomemoremarketorientedascountriesbecomericher.

AllenandGale(2000)haveputforwardtwoexplanationsfortheuniversalpopularityoffinancialmarkets:(i)governmentinterventionisregardedasanegativefactorandgovernmentfailuresareasimportantaproblemasmarketfailures,(ii)economictheory,pertainingtofirms,stressestheeffectivenessofmarketsinallocatingresources.

Empiralanalysisinvariousresearchesdonotemphaticallysuggestthesuperiorityofonesystemovertheother.Whateverbethetypeoffinancialsystem,bothfinancialintermediariesandfinancialmarkets



playacrucialroleinthedevelopmentofasoundfinancialsystem.Bothsystemscancoexistastheyencouragecompetition,reducetransactioncosts,andimproveresourceallocationwithintheeconomy,leadingtothedevelopmentofabalancedfinancialsystem.

FinancialInstitutionsProvideThreeTransformationServices

liability,asset,andsizetransformation

Maturitytransformation

Risktransformation

NATURE AND ROLE OF FINANCIAL INSTITUTIONS (INTERMEDIARIES) AND FINANCIALMARKETS

Financialinstitutions(intermediaries)arebusinessorganisationsservingasalinkbetweensaversandinvestorsandsohelpinthecreditallocationprocess.Goodfinancialinstitutionsarevitaltothefunctioningofaneconomy.Iffinanceweretobedescribedasthecirculatorysystemoftheeconomy,financialinstitutionsareitsbrain.Theymakedecisionsthattellscarcecapitalwheretogoandensurethatitisusedmostefficiently.Ithasbeenconfirmedbyresearchthatcountrieswithdevelopedfinancialinstitutionsgrowfasterandcountrieswithweakonesaremorelikelytoundergofinancialcrises.

Lendersandborrowersdifferinregardtotermsofrisk,return,andtermsofmaturity.Financialinstitutionsassistinresolvingthisconflictbetweenlendersandborrowersbyofferingclaimsagainstthemselvesand,inturn,acquiringclaimsontheborrowers.Theformerclaimsarereferredtoasindirect(secondary)securitiesandthelatterasdirect(primary)securities.

Financialinstitutionsprovidethreetransformationservices:

Liability,asset,andsizetransformationconsistingofmobilisationoffunds,andtheirallocationbyprovidinglargeloansonthebasisofnumeroussmalldeposits.

Maturitytransformationbyofferingthesaverstailormadeshorttermclaimsorliquiddepositsandsoofferingborrowerslongtermloansmatchingthecashflowsgeneratedbytheirinvestment.

Risktransformationbytransformingandreducingtheriskinvolvedindirectlendingbyacquiringdiversifiedportfolios.

Throughtheseservices,financialinstitutionsareabletotapsavingsthatareunlikelytobeacceptableotherwise.Moreover,byfacilitatingtheavailabilityoffinance,financialinstitutionsenabletheconsumertospendinanticipationofincomeandtheentrepreneurtoacquirephysicalcapital.

Theroleoffinancialinstitutionshasundergoneatremendoustransformationinthe1990s.Besidesprovidingdirectloans,manyfinancialinstitutionshavediversifiedthemselvesintoareasoffinancialservicessuchasmerchantbanking,underwritingandissuingguarantees.

FinancialMarkets

Types

MoneyMarketamarketforshorttermdebtinstruments

CapitalMarketamarketforlongtermequityanddebtinstruments

Segments

Primaryamarketfornewissues

Secondaryamarketfortradingoutstandingissues

Financial Markets

Financialmarketsareanimportantcomponentofthefinancialsystem.Theyareamechanismfortheexchangetradingoffinancialproductsunderapolicyframework.Theparticipantsinthefinancialmarketsaretheborrowers(issuersofsecurities),lenders(buyersofsecurities),andfinancialintermediaries.Financialmarketscomprisetwodistincttypesofmarkets:

themoneymarket

thecapitalmarket



MoneyMarketAmoneymarketisamarketforshorttermdebtinstruments(maturitybelowoneyear).Itisahighlyliquidmarketwhereinsecuritiesareboughtandsoldinlargedenominationstoreducetransactioncosts.Callmoneymarket,certificatesofdeposit,commercialpaper,andtreasurybillsarethemajorinstruments/segmentsofthemoneymarket.

Thefunctionsofamoneymarketare

toserveasanequilibratingforcethatredistributescashbalancesinaccordancewiththeliquidityneedsoftheparticipants

toformabasisforthemanagementofliquidityandmoneyintheeconomybymonetaryauthoritiesand

toprovidereasonableaccesstotheusersofshorttermmoneyformeetingtheirrequirementsatrealisticprices.

Asitfacilitatestheconductofmonetarypolicy,amoneymarketconstitutesaveryimportantsegmentofthefinancialsystem.

CapitalMarketAcapitalmarketisamarketforlongtermsecurities(equityanddebt).Thepurposeofcapitalmarketisto

mobiliselongtermsavingstofinancelongterminvestments

provideriskcapitalintheformofequityorquasiequitytoentrepreneurs

encouragebroaderownershipofproductiveassets

provideliquiditywithamechanismenablingtheinvestortosellfinancialassets

lowerthecostsoftransactionsandinformationand

improvetheefficiencyofcapitalallocationthroughacompetitivepricingmechanism.

Money Market and Capital Market

Thereisstronglinkbetweenthemoneymarketandthecapitalmarket:

Often,financialinstitutionsactivelyinvolvedinthecapitalmarketarealsoinvolvedinthemoneymarket.

Fundsraisedinthemoneymarketareusedtoprovideliquidityforlongterminvestmentandredemptionoffundsraisedinthecapitalmarket.

Inthedevelopmentprocessoffinancialmarkets,thedevelopmentofthemoneymarkettypicallyprecedesthedevelopmentofthecapitalmarket.

Acapitalmarketcanbefurtherclassifiedintoprimaryandsecondarymarkets.Theprimarymarketismeantfornewissuesandthesecondarymarketisonewhereoutstandingissuesaretraded.Inotherwords,theprimarymarketcreateslongterminstrumentsforborrowings,whereasthesecondarymarketprovidesliquiditythroughthemarketabilityoftheseinstruments.Thesecondarymarketisalsoknownasthestockmarket.

LinkBetweenthePrimaryandtheSecondaryCapitalMarket

Abuoyantsecondarymarketisindispensableforthepresenceofavibrantprimarycapitalmarket

Thesecondarymarketprovidesabasisforthedeterminationofpricesofnewissues.

Depthofthesecondarymarketdependsontheprimarymarket.

Bunchingofnewissuesaffectspricesinthesecondarymarket

Primary Capital Market and Secondary Capital Market

Eventhoughthesecondarymarketismanytimeslargerthantheprimarymarket,theyareinterdependentinmanyways.

Theprimarymarketisamarketfornewissues,butthevolume,pricing,andtimingofnewissuesareinfluencedbyreturnsinthestockmarket.Returnsinthestockmarketdependonmacroeconomicfactors.Favourablemacroeconomicfactorshelpfirmsearnhigherreturns,which,inturn,createfavourableconditionsforthesecondarymarket.Thisinturn,influencesthemarketpriceofthestock.Moreover,favourablemacroeconomicfactorsnecessitateraisingfreshcapitaltofinancenewprojects,expansion,andmodernisationofexistingprojects.Abuoyantsecondarymarket,inturn,inducesinvestorstobuynewissuesiftheythinkthatisagooddecision.Hence,abuoyantsecondarymarketisindispensableforthepresenceofavibrantprimary



capitalmarket.

Thesecondarymarketprovidesabasisforthedeterminationofpricesatwhichnewissuescanbeofferedintheprimarymarket.

Thedepthofthesecondarycapitalmarketdependsupontheactivitiesintheprimarymarketbecausethebiggertheentryofcorporateentities,thelargerthenumberofinstrumentsavailablefortradinginthesecondarymarket.Thesecondarymarketvolumesurgein200708waspartdrivenbyarampantprimarymarket,asnewlylistedstockstendtohaveahighturnover.

Newissuesofalargesizeandbunchingoflargeissuesmaydivertfundsfromthesecondarymarkettotheprimarymarket,therebyaffectingstockprices.

Characteristics of Financial Markets

Financialmarketsarecharacterisedbyalargevolumeoftransactionsandthespeedwithwhichfinancialresourcesmovefromonemarkettoanother.

Therearevarioussegmentsoffinancialmarketssuchasstockmarkets,bondmarketsprimaryandsecondarysegments,wheresaversthemselvesdecidewhenandwheretheyshouldinvestmoney.

Thereisscopeforinstantarbitrageamongvariousmarketsandtypesofinstruments.

Financialmarketsarehighlyvolatileandsusceptibletopanicanddistresssellingasthebehaviourofalimitedgroupofoperatorscangetgeneralised.

Marketsaredominatedbyfinancialintermediarieswhotakeinvestmentdecisionsaswellasrisksonbehalfoftheirdepositors.

Negativeexternalitiesareassociatedwithfinancialmarkets.Afailureinanyonesegmentofthesemarketsmayaffectothersegments,includingnonfinancialmarkets.

Domesticfinancialmarketsaregettingintegratedwithworldwidefinancialmarkets.Thefailureandvulnerabilityinaparticulardomesticmarketcanhaveinternationalramifications.Similarly,problemsinexternalmarketscanaffectthefunctioningofdomesticmarkets.

Inviewoftheabovecharacteristics,financialmarketsneedtobecloselymonitoredandsupervised.

Functions of Financial Markets

Thecostofacquiringinformationandmakingtransactionscreatesincentivesfortheemergenceoffinancialmarketsandinstitutions.Differenttypesandcombinationsofinformationandtransactioncostsmotivatedistinctfinancialcontracts,instrumentsandinstitutions.

Financialmarketsperformvariousfunctionssuchas

enablingeconomicunitstoexercisetheirtimepreference

separation,distribution,diversification,andreductionofrisk

efficientpaymentmechanism

providinginformationaboutcompanies.Thisspursinvestorstomakeinquiriesthemselvesandkeeptrackofthecompanies'activitieswithaviewtotradingintheirstockefficiently

transmutationortransformationoffinancialclaimstosuitthepreferencesofbothsaversandborrowers

enhancingliquidityoffinancialclaimsthroughtradinginsecuritiesand

providingportfoliomanagementservices.

Avarietyofservicesareprovidedbyfinancialmarketsastheycanaltertherateofeconomicgrowthbyalteringthequalityoftheseservices.

KEY TERMS

FormalFinancialSystem,InformalFinancialSystem,FinancialInstitutions,FinancialMarkets,FinancialInstruments,FinancialServices,FinancialDeepening,FinancialBroadening,BankbasedFinancialSystem,MarketbasedFinancialSystem,Freerider,MoneyMarket,CapitalMarket,PrimaryMarketandSecondaryMarket.

SUMMARY

1. Afinancialsystemisacomplex,wellintegratedsetofsubsystemsoffinancialinstitutions,markets,instruments,andserviceswhichfacilitatesthetransferandallocationoffunds,efficientlyandeffectively.

2. Thefinancialsystemsofmostdevelopingcountriesarecharacterisedbycoexistenceandcooperationbetweentheformalandinformalfinancialsectors.

3. Formalfinancialsystemsconsistoffoursegmentsorcomponents:financialinstitutions,financialmarkets,financial



instruments,andfinancialservices.4. Financialinstitutionsareintermediariesthatmobilisesavings

andfacilitatetheallocationoffundsinanefficientmanner.Financialinstitutionscanbeclassifiedintobankingandnonbanking,termfinance,specialised,sectoral,investment,andstatelevel.

5. Financialmarketsareamechanismenablingparticipantstodealinfinancialclaims.Themarketsalsoprovideafacilityinwhichtheirdemandsandrequirementsinteracttosetapriceforsuchclaims.

6. ThemainorganisedfinancialmarketsinIndiaarethemoneymarketandthecapitalmarket.Thefirstisamarketforshorttermsecuritieswhilethesecondisamarketforlongtermsecurities,i.e.securitieshavingamaturityperiodofoneyearormore.

7. Financialmarketsarealsoclassifiedasprimaryandsecondarymarkets.Whiletheprimarymarketdealsinnewissues,thesecondarymarketismeantfortradinginoutstandingorexistingsecurities.

8. Financialservicesarethosethathelpwithborrowingandfunding,lendingandinvesting,buyingandsellingsecurities,makingandenablingpaymentsandsettlements,andmanagingriskexposuresinfinancialmarkets.

9. TheRBIregulatesthemoneymarketandtheSEBIregulatesthecapitalmarket.

10. Thefoursubsystemsdonotfunctioninisolation.Theyareinterdependentandinteractcontinuouslywitheachother.Theirinteractionleadstothedevelopmentofasmoothlyfunctioningfinancialsystem.

11. Thefunctionsofafinancialsystemincludemobilisingandallocatingsavings,monitoringcorporateperformance,providingpaymentandsettlementsystems,optimumallocationofriskbearingandreduction,disseminatingpricerelatedinformation,offeringportfolioadjustmentfacility,loweringthecostoftransactions,andpromotingtheprocessoffinancialdeepeningandbroadening.

12. Thebasicelementsofawellfunctioningfinancialsystemare(i)astronglegalandregulatoryenvironment,(ii)stablemoney,(iii)soundpublicfinancesandpublicdebtmanagement,(iv)centralbank,(v)asoundbankingsystem(vi)aninformationsystem,and(vii)awellfunctioningsecuritiesmarket.

13. Thetwotypesoffinancialsystemdesignsare:bankbasedandmarketbased.

14. Atoneextremeisthebankdominatedsystem,suchasinGermany,whereafewlargebanksplayadominantroleandthestockmarketisnotthatimportant.Attheotherextreme,isthemarketdominatedfinancialsystem,asintheUS,wherefinancialmarketsplayanimportantrolewhilethebankingindustryismuchlessconcentrated.

REVIEW QUESTIONS

1. Whatisafinancialsystem?Discussthecomponentsofaformalfinancialsystem.

2. Discussthetypesoffinancialmarketsandtheirinterrelationship.

3. Whatarethecharacteristicsandfunctionsoffinancialmarkets?4. Amarketbasedfinancialsystemispreferableoverabankbased

system.Commentcritically.5. Afinancialsystemisawellintegratedsystemwhoseparts

interactwitheachother.Explain.

REFERENCES

1.Adams,Dale(1991),TakingaFreshLookatInformalFinance,inPhillipsCallier(ed.),FinancialSystemsandDevelopmentinAfrica,TheWorldBank,Washington,D.C.

2.Allen,FranklinandDouglasGale(2000),ComparingFinancialSystems,MITPress,Cambridge,Mass.

3.Arnold,L.andU.Walz(2000),FinancialRegimes,CapitalStructureandGrowth,EuropeanEconomicReview,Vol.16,pp.491508.

4.Bencivenga,ValerieR.andBrueaD.Smith(2003),MonetaryPolicyandFinancialMarketEvolution,TheFederalReserveBankofSt.Louis,July/August2003,pp.720.

5.Bhole,L.M.(1999),FinancialInstitutionsandMarkets,Structure,GrowthandInnovation,TataMcGrawHill,NewDelhi.

6.DemirgucKunt,A.andR.Levine(1999),BankbasedandMarketbasedFinancialSystems:CrossCountryComparisons,WorldBankPolicyResearchWorkingPaperNo.2143.

7.DemirgucKunt,A.andV.Maksimovic(2000),FundingGrowthinBankbasedandMarketbasedFinancialSystemEvidencefromFirm



LevelData,WorldBankPolicyResearchWorkingPaperNo.2432.

8.Germidis,Dimitri,DevisKesilerandRachelMeghir(1991),FinancialSystemsandDevelopment:WhataRolefortheFormalandInformalFinancialSector,DevelopmentCentreStudies,OECD,Paris.

9.InternationalFinancialCorporation(1999),FinancialInstitutions:LessonsofExperience,IFC,Washington,D.C.

10.Jalan,Bimal(2000),FinanceandDevelopmentWhichWayNow,RBIBulletin,June2000,pp.2945.

11.Low,CheeKeong(2000),FinancialMarketsinHongKong,SpringerVerlagSingaporeLtd.

12.Neave,Edwin(1998),FinancialSystems:PrinciplesandOrganisation,Routledge,London.

13.ReserveBankofIndia,ReportonCurrencyandFinance,19992000and200001.

14.Robinson,R.I.andD.Wrightsman(1981),FinancialMarkets,McGrawHill,London.

15.Rousseau,PeterL.andRichardSylla(2001),FinancialSystem,EconomicGrowthandGlobalization,NBERWorkingPaperNo.8323,June2001.

16.Shaw,G.S.(1973),FinancialDeepeninginEconomicDevelopment,OxfordUniversityPress,NewYork.

17.Singh,Ajit(1997),FinancialLiberalization,StockMarketsandEconomicDevelopment.TheEconomicJournal,vol.107(May),pp.77182.

18.Singh,AjitandB.A.Weisse,(1998),EmergingStockMarkets,PortfolioCapitalFlowsandLongTermEconomicGrowthMicroandMacroEconomicPerspectiveWorldDevelopment,vol.26,no.4(April),pp.60722.

19.Stigilitz,J.E.(1994),TheRoleofStateinFinancialMarkets,inM.BrunoandB.Pleskoviz(eds.),ProceedingsoftheWorldBankAnnualBankConferenceonDevelopmentEconomics1993,Washington,D.C.,WorldBank,pp.1952.


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2

The Financial System and the Economy

Chapter Objectives

Thischapterwillenableyoutodevelopanunderstandingofthefollowing:

1. Typesofeconomicunits

2. Roleofafinancialsystemintheeconomy

3. Nationalincomeaccounts

4. Flowoffundsanalysis

5. Trendsinsavingandinvestment

6. Trendsinhouseholdfinancialsavingandliabilities

7. Relationshipbetweenafinancialsystemandeconomicgrowth.

INTRODUCTION

Alleconomiesoperatewithastockofrealandfinancialassets.Realassetsmaybetangibleorintangible.Examplesoftangiblerealassetsarelandandnaturalresources,buildings,inventories,equipment,durables,andinfrastructure.Examplesofintangiblerealassetsarehumancapital,organisationalsystems,andgovernments.Everyassetrepresentssavingseitherbytheownerhimselforbylendersofsurplussavings.Mostoftherealassetsarefinancedthroughborrowings(suppliersofsurplussavings).Financialassets,orclaims,orsecurities,orinstrumentscomeintoexistencetoenabletransferofsavingsforinvestment.Financialassetsmaybeclassifiedasequityinstruments,debtinstruments,deposits,units,andinsurancepolicies.Inamodernmarketeconomy,therealandfinancialassetsmustinteractfortheprocessofcapitalformationtotakeplace.

TypesofEconomicUnits

Surplusspendingeconomicunits:Income>consumption+plannedinvestment

Deficitspendingeconomicunits:Income

11/01/2016 2TheFinancialSystemandtheEconomyTheIndianFinancialSystem:Markets,InstitutionsandServices,3rdEdition


spendingsectorcanbetermedasdemandingfinancialassetsorsupplyingloanablefunds.InIndia,thehouseholdsectorisanetsurplusspendingeconomicunit.Thehouseholdandothersectorsarediscussedindetailintheflowoffundsanalysis.

DeficitspendingEconomicUnitsTheseareunitswhoseconsumptionandplannedinvestmentexceedsincome.Thedeficitspendingeconomicunitshavenegativesavingstheyfinancetheirneedsbyborrowingorbydecreasingtheirstockoffinancialassets.Borrowingbydeficitspendingunitscreatesasupplyoffinancialsecuritiesordemandforloanablefunds.InIndia,thegovernmentandthecorporatesectoraredeficitspendingeconomicunits.

Thesurplussavingsofthesurplusspendinghouseholdunitshavetobetransferredtothedeficitspendingeconomicunits.Alinkintheformofafinancialsystemisnecessarytotransfersurplussavingstodeficitunits.Thesurplusanddeficitunitscanbebroughttogethereitherdirectlythroughexternalfinancingorindirectlythroughintermediation(banksandotherfinancialinstitutions).

Figure2.1illustrateshowsurplusspendingeconomicunitslendfundstofinancialintermediariesandfinancialmarketstwoimportantcomponentsofthefinancialsystem.Financialintermediariesissuesecondarysecuritieslikedeposits,insurancepolicies,andunitstotheultimatelenders.Theultimateborrowersmayacquirefundseitherbyissuingprimarysecuritiestofinancialintermediariesorbyissuingprimarysecuritiesinthefinancialmarkets.Thistransferoffundsfromthesurplusspendingsectortothedeficitspendingsectorthroughthefinancialsystemleadstocapitalformationandeconomicgrowth.Economicgrowth,insimpleterms,istheincreaseintherealnationalproductoroutputovertime.

Figure2.1FinancialSystemandEconomicGrowth

Besideslinkingsavingsandinvestment,thefinancialsystemhelpsinacc

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