UNIT 1: INTRODUCTION TO FINANCIAL SYSTEM IN INDIA 08 Hrs Overview of Financial System – Structure, Regulation & Functions – Financial Assets-Financial Instruments- Financial Markets – Capital Market – Money Market – Interlink between capital market and money market – Characteristics of Financial Market – Key elements of well-functioning of Financial system- Economic indicators of financial development.
Introduction to financial system Financial system facilitates the transfer of economic resources from one section of the economy to another. If a country has to be economically strong and developed, it depends on how well its financial system is regulated. The financial system is composed of the products and services provided by Financial Institutions, which includes banks, insurance companies, pension funds, organised exchanges and the many other companies that serve to facilitate economic transactions. Virtually all economic transactions are affected by one or more of these Financial Institutions these create financial instruments such as stocks and bonds, pay interest on deposits, lend money to credit worthy borrowers and created and maintained the payment system of modern economics.
Meaning The term financial system is a set of inter-related activities or services working together to achieve some predetermined purpose or goal. It includes different markets, the institutions, instruments, services and mechanisms which influence the generations of savings , investment, capital formation and growth. In simple terms, financial system refers to all the securities, intermediaries and markets that exist to make transfers from savers to borrowers possible.
Definition Prof S B Gupta defines the financial system as, “a set of institutional arrangements through which financial surpluses available in the economy are mobilized”.
Functions 1. Provision of liquidity- The major function of the financial system is the provision of money and monetary assets for the production of goods and services. The term liquidity refers to instruments and other assets which can be converted into cash readily without loss.
Regulatory bodies in Indian Financial System FINANCIAL SERVICES REGULATOR Banking products and services RBI Capital market SEBI Insurance sector IRDA New pension scheme PFRDA
Functions of SEBI ❖ Regulatory Functions: 1. Regulation of stock exchange and self regulatory organizations 2. Registration and regulation of stock brokers, sub-brokers, registrar to all issue, merchant bankers, underwriters, portfolio managers and such other intermediaries who are associated with securities market. 3. Registration and regulation of the working of collective investment schemes including mutual funds. 4. Prohibition of fraudulent and unfair trade practices relating to securities market. 5. Prohibition of insider trading in securities. 6. Regulating substantial acquisitions of shares and takeover of companies.
A financial instrument is a real or virtual document representing a legal agreement involving any kind of monetary value. Any asset which holds capital and can be traded in the market is referred to as a financial instrument. Some examples of financial instruments are cheques, shares, stocks, bonds, futures, and options contracts. Financial instruments may be divided into two types: cash instruments and derivative instruments. Financial instruments may also be divided according to an asset class, which depends on whether they are debt-based or equity-based. Foreign exchange instruments comprise a third, unique type of financial instrument.
Financial assets and services A financial asset is a liquid asset that gets its value from a contractual right or ownership claim. Cash, stocks, bonds, mutual funds, and bank deposits are all are examples of financial assets. Unlike land, property, commodities, or other tangible physical assets, financial assets do not necessarily have inherent physical worth or even a physical form. Rather, their value reflects factors of supply and demand in the marketplace in which they trade, as well as the degree of risk they carry.
Financial services include activities, benefits, and satisfactions, connected with the sale of money, that offer to users and customers, financial related value.
Common Types of Financial Assets According to the commonly cited definition from the International Financial Reporting Standards (IFRS), financial assets include:
Financial markets It is through financial markets and institutions that the financial system of an economy works. Financial markets refer to the institutional arrangements for dealing in financial assets and credit instruments of different types such as currency, cheques, bank deposits, bills, bonds etc.
Characteristics and Functions of Financial markets
Financial market classified into two they are: (i) Money Market (ii)Capital Market
MONEY MARKET Money market refers to a section of the financial market for buying and selling of securities with high liquidity and of short-term maturities, of one year or less, such as treasury bills, certificate of deposit and commercial papers. Over-the-counter trading is done in the money market through oral communication and without the help of any brokers. It is used by the participants as a way of borrowing and lending for the short term. Central bank, Government, Commercial banks, financial institutions, acceptance houses and Corporate firms are some of the major players.
Characteristics of money market
Money Market Instruments
Classification of capital market The capital market can be divided into 2 parts. Namely
Instruments issued in Capital market 1. Debt instruments: Issued through primary market and traded in secondary market. Contract is for a specific duration and interest is paid at specified periods. (Debentures, Bonds) 2. Equities (Common stock) 3. Preference shares: Redeemable/Cumulative/ Convertible. 4. Derivatives: These instruments derive there value from other securities, referred to as underlying assets. (MBS,ABS,Futures,Options,Swaps) 5. Mutual Funds
Distinction between primary and secondary market
Primary Market: It is a market for new issue of securities. It deals with those securities which are issued to the public for the first time. It provides the channel for sale of new securities by Government as well as companies. Primary Market is the market in which funds are raised by industrial and commercial enterprises from investors through issue of shares, debentures and bonds etc.
Function of primary market
Also termed as New Issue Market (NIM) After Issue Market (AIM) Role of the market Market where stocks are issued for the first time
Market where stocks are traded once issued Intermediaries Investment banks Brokers Sale of securities Directly by companies to investors Sold and purchased amongst investors and traders
Price of shares Fixed value Changes depending on the supply and demand of shares
households for business expansion. It provides channels for the government to raise funds from the public to finance public sector projects.
PRIMARY MARKET INSTRUMENTS 1. Initial Public Offer: An initial public offering is process of issuing share to the public for the first time by a company. Fresh issue of shares or selling existing securities by an unlisted company for the first time is known as Initial Public Offering. 2. Right issue: Right issue is method of issuing equity/securities in the primary market to existing shareholders when company issues additional capital. The shareholders may forfeit this right partially enable the company to issue additional capital to public. 3. Private placements: Refers to the allotment of shares by a company to few selected sophisticated investors, mutual funds, insurance companies and banks etc, In this method issue is placed with small number of finance restitution corporate bodies and high networks individuals. The financial intermediaries purchase the shares and sell them to investors at a later date at a suitable price. 4. Preferential allotment: Preferential allotment involves bulk allotment of fresh issue of shares by a company to individuals, venture capitalists and companies at a pre-determined price. Usually, a company chooses to make a preferential allotment to people who want to acquire a strategic stake in the company. 5. Buy-back of shares: It means the repurchase of outstanding shares by a company, in order to reduce the number of shares on the market. Companies will Buy-Back shares either to increase the value of shares or to eliminate any threats by share holders who may be looking for a controlling stake. A company buys back its shares from the existing shareholders usually at a price higher than market price. When it buys back, the number of shares outstanding in the market reduces.
SECONDARY MARKET A market where investors purchases securities or assets from other investors rather than issuing companies. The Secondary market, also called aftermarket, is the financial market in which previously issued financial instruments in primary markets such as stock and bonds are bought and sold.
a long period from capital market. A number of factors prompt borrowers and lenders to Resort to either the money market or the capital market which reflect the interdependence of the two markets.
Distinction between money and Capital market BASIS FOR COMPARISON
Meaning A segment of the financial market where lending and borrowing of short term securities are done.
A section of financial market where long term securities are issued and traded. Nature of Market Informal Formal
Financial instruments Treasury Bills, Commercial Papers, Certificate of Deposit, Trade Credit etc.
Shares, Debentures, Bonds, Retained Earnings, Asset Securitization, Euro Issues etc. Institutions Central bank, Commercial bank, non- financial institutions, bill brokers, acceptance houses, and so on.
Commercial banks, Stock exchange, non-banking institutions like insurance companies etc. Risk Factor Low Comparatively High
Liquidity High Low
Purpose To fulfil short term credit needs of the business.
To fulfil long term credit needs of the business.
Maturity period Within a year More than a year
Key elements of well-functioning of Financial system A well functioning financial system has complete markets with effective financial intermediaries and financial instruments allowing: - Investors to move money from the present to the future at a fair rate of return. - Borrowers to easily obtain capital - Hedgers to offset risk; and - Traders to easily exchange currencies and commodities.
The five key functions of a financial system in a country are: 1. Information production about investments and capital allocation 2. Monitoring investments and the exercise of corporate governance after providing financing. 3. Facilitation of trading, diversification and management of risk. 4. Mobilization and pooling of savings 5. Promoting the exchange of goods and services.
Financial sector development takes place when financial instruments, markets and intermediaries work together to reduce the costs of information, enforcement and transaction. Solid and well-functioning financial sector is powerful engine behind economic growth. It generates local saings which in turn lead to productive investment in local business. Effective banks canchannel International streamsof private remittances. The financial sector therefore provide the rudiments for income growth and job creation.
Economic indicators of financial development Economic indicators denote the degree of financial development in a country. Economic indicators are released through studies, surveys, sector reports and the data gathering efforts of government agencies. These indicators have wide reaching implications for every economic sector.
Some of the important indicators are: 1. GDP – Gross Domestic Product 2. Government regulation and fiscal policies 3. Industrial growth in the country 4. Inflation 5. Interest Rates The indicators under economic development are more towards the qualitative improvement of people in the country. A higher rate of these indicators shows a higher level of economic development.
