Chapter 2

THE FINANCIAL SYSTEM

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 OUTLINE

• Functions of the Financial System

• Financial Assets

• Financial Markets

• Financial Market Returns

• Financial Intermediaries

• Regulatory Infrastructure
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 THE FINANCIAL SYSTEM
Financial Institutions
Funds Funds
Commercial Banks
Insurance Companies
Deposits/Shares Mutual Funds Loans
Provident Funds
Non-Banking Financial
Companies

Suppliers of Funds Demanders of Funds

Individuals Individuals
Businesses Businesses
Governments Governments

Financial Markets
Funds Funds
Money Market
Capital Market
Securities Securities

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 FUNCTIONS OF THE FINANCIAL SYSTEM

• Payment System

• Pooling of Funds

• Transfer of Resources

• Risk Management

• Price Information for Decentralised Decision Making

• Dealing with Incentive Problem

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 FUNCTIONS OF THE FINANCIAL SYSTEM
Payment System
Depository financial intermediaries such as banks are the pivot of
the payment system. Credit card companies play a supplementary
role.
Pooling of Funds
Financial markets and intermediaries facilitate the pooling of the
household savings for financing business.
Transfer of Resources
The financial system facilitates the efficient life-cycle allocations
of household consumption, the efficient allocation of physical
capital to its most productive use, and the efficient separation of
ownership from management.
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 FUNCTIONS OF THE FINANCIAL SYSTEM
Risk Management
A well-developed financial system offers a variety of
instruments that enable economic agents to pool, price, and
exchange risk
The three basic methods of managing risk are : hedging,
diversification, and insurance
Price Information for
Decentralised Decision Making
Interest rates and security prices are used by households in
their consumption-saving-investment decisions and by firms in
their investment and financing decisions

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 FUNCTIONS OF THE FINANCIAL SYSTEM

Dealing with Incentive Problems

Information asymmetry leads to moral hazard and adverse

selection, which are broadly referred to as agency problems.

Financial intermediaries like banks and venture capital

organizations can solve the problem of informational
asymmetry by handling sensitive information discreetly and
developing a reputation for profitable activity

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 FINANCIAL SECTOR REFORMS IN
INDIA
The financial sector reforms initiated from the early 1990s have focused
on the following objectives:
• Removal of financial repression.
• Creation of an efficient, productive, and profitable financial sector.
• Evolution of market-determined interest rates.
• Granting of operational and functional autonomy to institutions.
• Opening of operational and functional autonomy to institutions.
• Opening up of the external sector in a calibrated fashion.
• Maintenance of financial stability in face of domestic and external
disturbances.
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 FINANCIAL ASSETS

Financial assets are intangible assets that represent

claims to future cash flows. The terms financial asset,
instrument, or security are used interchangeably

Examples :
• A 10-year bond issued by the GOI carrying an interest
rate of 7 percent.

• Equity shares issued by TCS to the general investing

public through an initial public offering.

• Call options granted by WIPRO to its employees.

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 FINANCIAL MARKETS

A financial market is a market for creation and

exchange of financial assets.

Financial markets play a very pivotal role in

allocating resources in the economy by performing three
important functions as they :

• Facilitate price discovery.

• Provide liquidity.
• Reduce the cost of transacting.

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 FUNCTIONS OF FINANCIAL MARKETS
Facilitate Price Discovery
The continual interaction among numerous buyers and sellers who
participate in financial markets helps in establishing the prices of
financial assets
Provide Liquidity
Thanks to the liquidity provided by financial markets, it is possible for
companies (and other entitities) to raise long-term funds from investors
with short-term horizons
Reduce the Costs of Transacting
Financial markets considerably reduce the following costs of
transacting
• Search cost
• Information cost

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 CLASSIFICATION OF FINANCIAL MARKETS

DEBT MARKET
NATURE OF CLAIM
EQUITY MARKET
MONEY MARKET
MATURITY OF CLAIM
CAPITAL MARKET
PRIMARY MARKET
SEASONING OF CLAIM
SECONDARY MARKET
CASH OR SPOT MARKET
TIMING OF DELIVERY
FORWARD OR FUTURES MARKET
EXCHANGE-TRADED MARKET
ORGANISATIONAL
STRUCTURE OVER-THE-COUNTER MARKET

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 FINANCIAL MARKET RETURNS
• Interest Rate
Function of the unit of account, maturity, and default risk

• Rate of Return on Risky Assets

Cash dividend Ending price – Beginning price
r= +
Beginning price Beginning price

Dividend yield Capital yield

• Inflation and Real Interest Rate

1 + Nominal rate
1 + Real rate =
1 + Inflation rate
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 DETERMINANTS OF RATES OF RETURN

• Expected Productivity of Capital

• Degree of Uncertainty about the Productivity of Capital

• Time Preferences of People

• Degree of Risk Aversion

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 EQUILIBRIUM IN FINANCIAL MARKETS
(a) Supply and demand for loanable funds and determination of
interest rate

Interest rate
Sf (lending)
S’f
ie

i’e

Df
(borrowing)

0 A B
Amount of loanable funds

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(b) Supply and demand for securities and determination of prices

Price
SS (borrowing)

P’e

Pe
D’s

Ds (lending)

0 A’ B’
Amount of securities

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 FINANCIAL INTERMEDIARIES
Reserve Bank
of India

Commercial Developmental Insurance Other public Mutual Non-banking

banks financial companies sector financial funds financial
institutions institutions corporations

Public All India Life Insurance Unit Public

POSB
sector institutions Corporation Trust of sector
banks of India India firms

Private sector
NABARD
insurance
companies

Private State level Other Private

General Insurance NHB
sector institutions mutual sector
Corporation of
banks funds firms
India

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 RATIONALE FOR FINANCIAL
INTERMEDIARIES

• Diversification

• Lower Transaction Cost

• Economies of Scale

• Confidentiality

• Signalling

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 RATIONALE FOR FINANCIAL INTERMEDIARIES
Diversification The pool of funds mobilised by financial
intermediaries is invested in a broadly diversified portfolio of
assets (loans, stocks, bonds and so on).
Lower Transaction Cost The transaction cost in percentage terms
decreases as the transaction size increases.
Economies of Scale Financial institutions enjoy economies of scale
Confidentiality Information shared with financial intermediaries
may be kept confidential whereas information disclosed to
numerous individual investors is in public domain.
Signalling Financial intermediaries can pick up and interpret
signals and cues better. So they perform a signalling function for
the investment community.

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 REGULATARY INFRASTRUCTURE

• RESERVE BANK OF INDIA

• SEBI

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 KEY TRENDS IN THE
INDIAN FINANCIAL SYSTEM

• Market-determined interest rates and greater volatility

of interest rates

• Emergence of universal banks

• Emphasis on prudential regulation and supervision

• Gradual integration with the global financial system

• Increase in financial innovation

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 SUMMING UP
• The financial system – consisting of a variety of institutions, markets,
and instruments related in a systematic manner – provides the principal

means by which savings are transformed into investments.

• The financial system provides a payment mechanism, enables the
pooling of funds, facilitates the management of uncertainty, generates
information for decentralised decision making, and helps in dealing with
informational asymmetry.
• Financial assets represent claims against the future income and wealth
of others. Financial liabilities, the counterparts of financial assets,
represent promises to pay some portion of prospective income and
wealth to others.
• The important financial assets and liabilities in our economy are money,
demand deposit, short-term debt, intermediate-term debt, long-term
debt, and equity stock.
• A financial market is a market for creation and exchange of financial
assets. Financial markets facilitate price discovery, provide liquidity,
and reduce the cost of transacting.
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• There are different ways of classifying financial markets. The important
bases for classification are: type of financial claims, maturity of claims,
new issues versus outstanding issues, timing of delivery, and nature of
organisational structure.
• The interest rate on any type of loan (or fixed income security) depends
on several factors, the most important being the unit of account, the
maturity, and the default risk.
• Just as a distinction is made between nominal and real prices, so too a
distinction is made between nominal and real interest rates. The nominal
interest rate on a bond is the rate of return in nominal terms whereas the
real rate is the nominal rate adjusted for the inflation factor.
• The principal determinants of rates of return in a market economy are :
expected productivity of capital; degree of uncertainty characterising
the productivity of capital; time preferences of people; and degree of
risk-aversion.
• An equilibrium price clears the market for loanable funds. It is
expressed as an interest rate - the amount per rupee per annum
that the lender gets and the borrower pays.
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• Despite a good deal of deregulation in recent years, interest rates in India
continue to be substantially regulated.
• Financial intermediaries are firms that provide services and products
that customers may not be able to get more efficiently by themselves in
financial markets.
• Financial intermediaries seem to offer several advantages :
diversification, lower transaction cost, economies of scale, confidentiality,
and signaling benefit.
• The major financial intermediaries in India are commercial banks,
developmental financial institutions, insurance companies, mutual funds,
non-banking financial companies, and merchant banks.
• As a maker and enforcer of laws in a society, the government has the
responsibility for regulating the financial system. The two major
regulatory arms of the Government of India are the Reserve Bank of
India (RBI) and the Securities and Exchange Board of India (SEBI).

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