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Indian Financial System Introduction

A Financial System plays a vital role in the economic growth of a country It intermediates between those who have surplus funds and those who need them It is a complex, well integrated set of sub-systems of financial institutions, markets, instruments and services which facilitates the transfer and allocation of funds efficiently and effectively

Indian Financial System - Introduction


Formal and informal Financial Sectors Formal Organized, institutional and regulated system Informal Unorganized, flexible, low transaction cost, minimal default risk, higher rate of interest Interpenetration exists between formal and informal systems in terms of operation, participation and nature of activities which in turn have led to their coexistence. Priority should be accorded to development of efficient formal financial system

Indian Financial System - Introduction


Control Formal financial system is controlled by Ministry of Finance, RBI, SEBI,IRDA and other regulatory bodies Informal financial system Consists of moneylenders, group of persons such as partnership firms, funds or associations, pawn brokers etc function under a system of their own rules

Indian Financial System - Introduction


Formal Financial System Institutions, Markets, Instruments and Services Financial Institutions Banking and Non- Banking. Banks can accept deposits and give loans whereas NonBanking Companies can give only loans unless specifically permitted by RBI to accept deposits. Development FIs, NBFCs, HFCs are major institutional purveyors of credit. Other specialized finance institutions are EXIM Bank, TFCI, IFDC, NABARD, NHB etc State Level FIs are SFCs, SIDC. Post reform there has been tremendous change in role and activity

Indian Financial System - Introduction


Financial Markets Mechanism enabling participants to deal in financial claims. Markets provide a facility in which demand and supply interact to set a price for such claims Organized markets in India are Money market and Capital Market. Money Market is for short term securities and Capital Market is for long term securities which are those having maturity period of one or more years

Indian Financial System - Introduction


Financial Markets are classified as Primary and Secondary markets Primary markets deal with new issues Secondary markets deal with outstanding or existing securities. There are two components OTC market and Exchange traded market. Govt. securities market is OTC market where it is spot trade. In Exchange traded market, trading takes place over a trading cycle in stock exchanges.

Indian Financial System - Introduction


Financial Instruments Different Financial Instruments can be designed to suit the risk and return preferences of different classes of investors Savings and Investments are linked through a wide variety of complex financial instruments known as securities . Securities are defined in the Securities Contracts Regulation Act (SCRA), as including shares, scripts, stocks, bonds, debentures or other marketable securities of a similar nature

Indian Financial System - Introduction


Financial Securities are Financial Instruments that are negotiable and tradeable. They may be primary or secondary securities. Primary/Direct are directly issued by ultimate borrowers to ultimate savers such as shares, debentures. Secondary/Indirect are those that are issued by financial intermediaries to ultimate borrowers like Bank deposits, Mutual fund units, insurance policies etc

Indian Financial System - Introduction


Financial Instruments differ in terms of marketability, liquidity, reversibility, type of options, return, risk and transaction costs. Financial instruments help financial markets and financial intermediaries to perform the important role of channelizing funds from lenders to borrowers.

Indian Financial System - Introduction


Financial Instruments It is a claim against a person or an institution for payment, at a future date, of a sum of money and/or a periodic payment in the form of interest or dividend. FIs represent paper wealth shares, de mat shares, debentures, bonds and notes. FIs are marketable

Indian Financial System - Introduction


Financial Services are those that help in: Borrowing Funding Lending Investing Buying Selling Enabling payments and settlements Managing Risk exposures in financial markets

Indian Financial System - Introduction


Intermediating services link the saver and borrower which in turn leads to capital formation Liquidity is essential for smooth functioning of a financial system. It is enhanced through trading in securities Liquidity is provided by brokers who act as dealers by assisting sellers and buyers and also market makers who provide buy and sell quotes

Indian Financial System - Introduction


The producers of financial services are financial intermediaries such as banks, insurance companies, mutual funds and stock exchanges. They provide key financial services such as merchant banking, leasing, hire purchase and credit rating. These services bridge the gap between lack of knowledge on the part of investors and the increasing sophistication of financial instruments & markets

Indian Financial System - Introduction


Financial Services are vital for creating of firms, industrial expansion and economic growth Before investors lend money, they need to be reassured that it is safe to exchange securities for funds. The financial regulators provide this reassurance. The regulator regulates the conduct of issuers of securities and the intermediaries to protect the interests of investors in securities and increases their confidence in markets.

Indian Financial System - Introduction


RBI regulates the Money market SEBI regulates the Capital market Securities Market is regulated by DEA, DCA, RBI and SEBI A high-level committee on capital and financial markets coordinates the activities of these agencies Intermediation among the above components Interdependent All four coordinate continuously Interactive leads to development of a smoothly functional system

Indian Financial System - Introduction


Close Links with the financial markets in economy Competing with each other Financial Intermediaries rely on financial markets to raise funds whenever the need arises. This increases the competition between financial markets and financial intermediaries for attracting investors and borrowers

Indian Financial System - Introduction


Functions of a Financial System
Link Savers and Investors Help in mobilizing and allocating the savings efficiently and effectively Monitor Corporate Performance Provide payment and settlement systems Optimum allocation of risk-bearing and reduction Disseminate price related information Offer portfolio adjustment facility Lower the cost of transactions Promote the process of financial deepening and broadening

Indian Financial System - Introduction


Key element of a Financial System Strong legal and regulatory environment Stable money Sound public finances and public management A Central Bank Sound banking system Information system Well functioning securities market

debt

Indian Financial System - Introduction


Financial System Designs Bank based bank dominated system where few large banks play a dominant role and stock market is not important (Germany) Market based Financial markets play an important role while the banking industry is much less concentrated (US)

Indian Financial System - Introduction


Nature and Role of Financial Institutions (Intermediaries) and Financial Markets Liability, Asset and size transformation Maturity transformation Risk transformation

Indian Financial System Introduction


Financial Intermediaries Liability, asset and size transformation consisting of mobilization of funds and their allocation by providing large loans on the basis of numerous small deposits Maturity transformation by offering the savers tailormade short-term claims or liquid deposits and so offering borrowers long-term loans matching the cash flows generated by their investment Risk transformation by transforming and reducing the risk involved in direct lending by acquiring diversified portfolios

Indian Financial System - Introduction


Financial Markets These are a mechanism for the exchange trading of financial products under a policy framework. Money market a market for short term debt instruments Capital market a market for long term equity and debt instruments

Indian Financial System - Introduction


Segments Primary a market for new issues Secondary a market for trading outstanding or existing securities

Indian Financial System - Introduction


Functions of Money Markets To serve as an equilibrating force that redistributes cash balances in accordance with liquidity needs of the participants To form a basis for the management of liquidity and money in the economy by monetary authorities and To provide reasonable access to the users of short-term money for meeting their requirements at realistic prices As it facilitates conduct of monetary policy, it is a very important segment of financial system

Indian Financial System - Introduction


Functions of Capital Markets Mobilize long-term savings to finance long-term investments Provide risk capital in the form of equity or quasi-equity entrepreneurs Encourage broader ownership of productive assets Provide liquidity with a mechanism enabling the investor to sell financial assets Lower the costs of transactions and information and Improve the efficiency of capital allocation through a competitive pricing mechanism

Indian Financial System - Introduction


Money market and capital market There is strong link between money market and capital market Financial institutions involved in capital market are also involved in the money market Funds raised in money market are used to provide liquidity for long-term investment and redemption of funds in capital market Development of money market precedes the development of capital market

Indian Financial System - Introduction


Link between Primary Capital Market and Secondary Capital Market Primary market is for new issues but volume, pricing and timing of new issues are influenced by returns in the stock market. Secondary market is for existing securities. A buoyant secondary market in turn induces investors to buy new issues if they think that is a good decision.

Indian Financial System - Introduction


A buoyant secondary market is indispensable for the presence of a vibrant primary capital market The secondary market provides a basis for the determination of prices of new issues Depth of the secondary market depends on the primary market Bunching of new issues affects prices in secondary market

Indian Financial System - Introduction


Characteristics of Financial Markets
Large volume of transactions and the speed with which financial resources move from one market to another Various segments stock markets, bond marketsprimary and secondary segments, where savers themselves decide when and where they should invest Scope for instant arbitrage among various markets and types of instruments

Indian Financial System - Introduction


Highly volatile and susceptible to panic and distress selling as the behaviour of a limited group of operators can get generalized Dominated by financial intermediaries who take investment decisions as well as risks on behalf of their depositors Negative externalities are associated with financial markets. A failure in any one segment of these markets may affect other segments, including non-financial markets Domestic financial markets are getting integrated with worldwide financial markets. The failure and vulnerability in a particular domestic market can have international ramifications. Problems in external markets can effect the functioning of domestic markets.

Indian Financial System - Introduction


Functions of Financial Markets Enabling economic units to exercise their time preference Separation, distribution, diversification and reduction of risk Efficient payment mechanism Providing information about companies. This spurs investors to make inquiries themselves and keep track of the companies activities with a view to trading in their stock efficiently Transformation of financial claims to suit the preferences of both savers and borrowers

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