Chapter -I

Financial System An
Overview

Contents:
Introduction to Financial System
Functions of Financial System
Financial Markets
Money Market
Capital Market
Primary Market
Secondary Market

Role of Financial
Institutions/Intermediaries
Necessary Steps for Sound Financial
System

Financial System
The word "system", in the term "financial system",
implies a set of complex and closely connected or
interlined institutions, agents, practices, markets,
transactions, claims, and liabilities in the economy.
The financial system is concerned about money,
credit and finance-the three terms are intimately
related yet are somewhat different from each
other.
The whole financial system consists of financial
market, financial instruments and financial
intermediation.

Continued..

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to users.
A business person may need additional capital for
inventory, and individuals and governments earn a
rate of return from their savings.
Businesses can borrow from the bank to obtain
capital to purchase inventory. These are typical
transactions that make up the financial system.

Understanding the Financial System

Financial System

Savers
Users
Financial Institutions
Financial Markets

Savings is a function of many variables.

Funds can be transferred between users and
savers directly or indirectly.

The Role of a Financial System

In a financial system different parties
participate in or perform different functions
but the common feature of all those
functions is the transfer of money from
surplus to deficit economic agents.
Transfer of funds from ultimate Lenders to
ultimate borrowers can be made
through direct lending;
through trading in organized securities markets
or
indirectly through financial intermediaries.

Flow of Funds in the Financial

System

Functions of the Financial

System
To link the savers & investors.
To inspire the operators to monitor
the performance of the investment.
To achieve optimum allocation of risk
bearing.
It makes available price - related
information.
It helps in promoting the process of
financial deepening and broadening.

An Overview of the
Financial System

What is Financial Market?

Financial markets are places where financial
instruments are bought and sold.
These markets are the economys central
nervous system.
These markets enable both firms and
individuals to find financing for their
activities.
These markets promote economic efficiency:
They ensure resources are available to those
who put them to their best use.
They keep transactions costs low.
3-10

The Role of Financial Markets

1. Liquidity:
Ensure owners can buy and sell
financial instruments cheaply.
Keeps transaction costs low.

2. Information:
Pool and communication information
about issuers of financial instruments.

3. Risk sharing:
Provide individuals a place to buy and
sell risk.
3-11

Components of Financial Market

I- Money Market

I - What is Money Market?

A market for dealing in monetary assets of short
term nature, less than one year.
Enables raising up of short term funds for meeting
temporary shortage of fund and obligations and
temporary deployment of excess fund.
Major participants are: Central Bank and
Commercial Banks
Major objectives:
Equilibrium mechanism for short term surpluses
and deficits.
Focal point for infuencing liquidity in economy.
Access to users of short term funds at reasonable
cost.

Components of Money Market

Call

A. Call Money Market

The call money market is a market for

extremely short period loans say one day to
fourteen days.
So, it is highly liquid.
The loans are repayable on demand at the
option of either the lender or the borrower.
The special feature of this market is that the
interest rate varies from day-to-day and even
from hour-to-hour and centre-to-centre.
It is very sensitive to changes in demand and
supply of call loans.

B-Treasury Bills

Treasury Bills are short term (up to one year)

borrowing
instruments
of
the
union
government.
It is a promise by the Government to pay a
stated sum after expiry of the stated period
from the date of issue (14/91/182/364 days i.e.
less than one year).
It is highly liquid because its repayment is
guaranteed by the government.
It is an important instrument for short-term
borrowing of the government.

C- Commercial Bill Market

It is a market for bills of exchange arising
out of genuine trade transactions.
In the case of credit sale, the seller may
draw a bill of exchange on the buyer.
The buyer accepts such a bill promising to
pay at a later date the amount specified in
the bill.
The seller need not wait until the due date
of the bill. Instead, he can get immediate
payment by discounting the bill.
It is freely negotiable by endorsement and

D - Short-term Loan Market:

It is a market where short-term loans are

given to corporate customers for meeting
their working capital requirements.
Commercial banks play a significant role in
this market.
Commercial banks provide short term loans
in the form of cash credit and overdraft.
Overdraft facility is mainly given to business
people whereas cash credit is given to
industrialists.
Overdraft is purely a temporary accommodation
and it is given to in the current itself.

II - What is Capital Market?

A market for long term funds
Focus
on
financing
of
fixed
investments
Main participants are mutual funds,
insurance
organizations,
foreign
institutional investors, corporate and
individuals.
Divided in to two segments:
Primary market and
secondary market

A - Primary/New Issue
Market
A market for new issues i.e. a market for
fresh capital.
Provides the channel for sale of new
securities, not previously available.
Provides opportunity to issuers of
securities; government as well as
corporate.
To raise resources to meet their
requirements
of
investment
and/or
discharge some obligation.
Does not have any organizational setup.

B - Secondary market/ Stock

Market

A place where buyers and sellers of

securities can enter into transactions to
purchase
and
sell
shares,
bonds,
debentures etc.
A market for old/existing securities.
It enables corporates, entrepreneurs to
raise resources for their companies and
business ventures through public issues.
It has physical existence
Vital functions are:
Nexus between savings and investments
liquidity to investors

III FinancialInstitutions/interme
diaries
The role of the intermediary was mostly
related to ensure transfer of funds from
the lender to the borrower.
This service was offered by banks, FIs,
brokers, and dealers.
However, as the financial system
widened along with the developments
taking place in the financial markets,
the scope of its operations also
widened.

Cont
Some of the important intermediaries
operating the financial markets include;
Investment bankers,
Underwriters
Stock exchanges
Portfolio managers
Mutual funds
Financial advisors and
Financial consultant
23

Cont
Among other services, they earn a return on
their money and avoidingrisk; e.g.,
banks
insurance companies
finance companies
investment banks
mutual funds
brokerage houses

24

Types of Financial
Intermediaries

A. commercial banks
Collect savings primarily in the form of
deposits and traditionally finance working
capital requirement of corporate.
With the emerging needs of economic and
financial system banks have entered in to:
Term lending business particularly in the
infrastructure sector,
Capital market directly and indirectly,
Retail finance such as housing finance,
consumer finance
Enlarged
geographical
and
functional
coverage

B. Non-banking finance companies (NBFC)

A Non-Banking Financial Company (NBFC)

is a company registered under the
Companies Act, engaged in the business of
loans and advances, acquisition of
shares/stocks/ bonds/debentures/securities
issued by Government or local authority or
other marketable securities of a like
nature, leasing, hire-purchase, insurance
business, etc.
Provide variety of fund/asset-based and
non-fund based/advisory services.
Their funds are raised in the form of public
deposits ranging between 1 to 7 years

Depending upon the nature and type of

service provided, they are categorized
into:

Asset finance companies

Housing finance companies
Venture capital funds
Merchant banking organisations
Credit rating agencies
Factoring and forfaiting organisations
Stock brokering firms

C. Mutual Funds
A mutual fund is a company that pools money
from many investors and invests in well
diversified portfolio of sound investment.
Issues securities (units) to the investors (unit
holders) in accordance with the quantum of
money invested by them.
Profit shared by the investors in proportion to
their investments.
Set up in the form of trust and has a sponsor,
trustee, asset management company and
custodian.
Advantages in terms of convenience, lower

Mutual Fund Operation Flow

Chart

D. Insurance Organizations
They invest the savings of their policy
holders in exchange promise them a
specified sum at a later stage or upon the
happening of a certain event.
Provide the combination of savings and
protection.
Through the contractual payment of
premium creates the desire in people to
save.

Necessary Steps for Sound

Financial System
Strengthen bank balance sheets and
capital ratios
Introduce innovative financial instruments
Improve competition in banking sector
Privatise banks and encourage foreign
ownership
Develop primary and secondary markets
Develop capital markets
Improve regulatory capacity

THANK
YOU.