Financial System Finance (Noun, Verb) The American Heritage® Dictionary of the

English Language, Fourth Edition defines the term as under-

1:"The science of the management of money and other assets.";2: "The management of money, banking, investments, and credit. ";3: "finances Monetary resources; funds, especially those of a government or corporate body"4: "The supplying of funds or capital."

Financial System Finance as a function (i.e. verb) is defined

by the same dictionary as under- 1:"To provide or raise the funds or capital

for": financed a new car2: "To supply funds to": financing a daughter through law school.3: "To furnish credit to".

:"the commercial activity of providing funds and capital"4: "the branch of economics that studies the management of money and other assets"5: "the management of money and credit and banking and investments"

Financial System System: Set of complex and closely

connected or interlinked institutions, agents, practices, markets, transactions, claims, and liabilities in the economy

Financial System: Money, Credit, Finance Heart to human body: Important for

Economy A financial system functions as an intermediary

and facilitates the flow of funds from the areas of surplus to the areas of the deficit.

Money Generally accepted as payment for

goods and services and repayment of debts

Functions of money: Medium of Exchange Unit of Account Store of value Standard of deferred payment Money forms: Commodity Money and

Fiat Money

Measures of Money M1:Currency (coins and bills) and

checking account deposits M2: Currency, checking account

deposits and savings account deposits

M3: M2 plus time deposits M0: Currency plus deposits of banks

and other institutions at the central bank

Credit Money Loaned A method of paying for goods or

services at a later time, usually paying interest as well as the original money

Finance Activity by which claims to resources

are either assembled from those released by domestic savings, obtained from abroad, or specifically created usually as bank deposits or notes and then placed in the hands of investors.

Investments Activity by which resources are

actually committed to production Volume of capital formation: Intensity

of savings, finance and investment. Conversion of savings to investment:

Transfer Process

Transfer Process Genesis of Financial System: Divorce

between savings and investment Relationship between savings and

investment vary considerably among economic units

Goldsmith’ designated categories of economic units: Savings-surplus units (Savings in excess of investments), Economic Units (Investments exceed their savings) and Neutral units (Savings equal to investments)

Financial System

Function of efficient allocation of funds

Financial innovation Growth of technology Rudimentary Finance Direct Finance Indirect Finance

Rudimentary Finance Financial System of underdeveloped

or traditional economy Per capita output low and declining Absence of an array of financial

assets/ instruments that would stimulate savings

Absence of an array of financial markets that would allocate savings competitively to investment

Direct Finance Improvement over rudimentary

finance by removing the obstacles to efficient capital formation

Improved capital formation under direct finance through: Financial assets/ instruments, Brokers/ Investment Bankers, Secondary Markets/ Stock Exchanges

Financial Assets/ Instruments (Securities)

Financial instrument/ asset is a claim against another economic unit and is held as a store of value and for the return that is expected.

Examples: Shares, Debentures, etc. Financial assets stimulate capital

formation and speedy economic development

Brokers/ Investment Bankers

Find savers and bring them with economic units needing funds

Brokerage function, Underwriting function

Secondary Markets/ Stock Exchanges/ Markets

Provide savers with ability/ facility to dispose of their investment portfolio and realise cash to finance their current consumption

Provide liquidity and marketability

Indirect Finance Flow of savings from savers to entrepreneurs

through intermediary financial institutions like mutual funds, insurance companies, etc.

Services offered by financial intermediaries: Convenience (Divisibility, Flexibility, Maturity) Lower risk Expert Management Economies of Scale Channelisation of savings (Encouraging,

Sponsoring, Discriminating between various industries)

Financial System Functions

Saving FunctionLiquidity FunctionPayment FunctionRisk FunctionPolicy Function

Saving Function Public saving find their way into the

hands of those in production through the financial system. Financial claims are issued in the money and capital markets which promise future income flows. The funds with the producers result in production of goods and services thereby increasing society living standards.

Liquidity Function The financial markets provide the

investor with the opportunity to liquidate investments like stocks, bonds, debentures, etc. whenever they need the fund.

Payment Function The financial system offers a very

convenient mode for payment of goods and services. Cheque system, credit card system etc are the easiest methods of payments. The cost and time of transactions are drastically reduced.

Risk Function The financial markets provide protection

against life, health and income risks. These are accomplished through the sale of life and health insurance and property insurance policies. The financial markets provide immense opportunities for the investor to hedge himself against or reduce the possible risks involved in various investments

Policy Function The government intervenes in the

financial system to influence macroeconomic variables like interest rates or inflation so if country needs more money government would cut rate of interest through various financial instruments and if inflation is high and too much money is there in the system then government would increase rate of interest.

Financial System: Composition

Financial System: Intermediary

Intermediary Market Role

Stock Exchange Capital MarketSecondary Market to

securities

Investment BankersCapital Market,

Credit Market

 Corporate advisory services, Issue of securities

UnderwritersCapital Market,

Money Market

Subscribe to unsubscribed portion of securities

Registrars, Depositories, Custodians Capital Market

Issue securities to the investors on behalf of the company and handle share transfer activity

Primary Dealers Satellite Dealers Money Market

Market making in government securities

Forex Dealers Forex MarketEnsure exchange ink

currencies

Indian Financial System Phases

Upto 1951 !951 to the mid-eighties After early nineties

Defined as the market in which financial assets are created or transferred.

These assets represent a claim to the payment of a sum of money sometime in the future and/or periodic payment in the form of interest or dividend.

Classification

Money market(Short term instrument)

Capital markets(Long term instrument)

The most important distinction between the two:

The difference in the period of maturity.

Main Function To channelize savings into short term productive investments like working capital .

Instruments in Money MarketCall money marketTreasury bills marketMarkets for commercial paperCertificate of depositsBills of ExchangeMoney market mutual fundsPromissory Note

Part of the national money market

Day-to day surplus funds mainly of banks are traded

Short term in nature

Maturity of these loans vary from 1 to 15 days

Lent for 1 day: Call money

Lent for more than 1 day but less than 15 days: Notice money

Convenient interest rate

Highly liquid loan repayable on demand

Unsecured Promissory note.

Issued by well known companies with strong and high credit rating.

Sold directly by the issuers to investors or through agents like merchant banks and security houses.

Flexible Maturity

Low interest rates with compared to banks.

Imparts a degree of financial stability to the system.

Referred as note payable in accounting

It is a contract detailing the terms of a promise by one party (the maker) to pay a sum of money to the other (the payee).

The obligation may arise from the repayment of a loan or from another form of debt.

For example, in the sale of a business, the purchase price might be a combination of an immediate cash payment and one or more promissory notes for the balance.

Defined as short term deposit by way of usance promissory notes.

Greater flexibility to investors in the deployment of surplus funds.

Permitted by the RBI to banks

Maturity of not less than 3 months and upto 1 year.

Transferable in nature

Free negotiability and limited flexibility

Invest primarily in money market instruments of very high quality.

RBI and public financial institution can set it either directly or through its existing subsidiaries.

MMMFOpen EndedClose Ended

Provided resources needed by medium and large scale industries.

Purpose for these resourcesExpansionCapacity ExpansionInvestmentsMergers and Acquisitions

Deals in long term instruments and sources of funds

Main Activity

Functioning as an institutional mechanism to channelize funds from those who save to those who needed for productive purpose.

Provides opportunities to various class of individuals and entities.

Primary Markets Secondary MarketsWhen companies need financial resources for its expansion, they borrow money from investors through issue of securities.

The place where such securities are traded by these investors is known as the secondary market.

Securities issued a)Preference Sharesb)Equity Sharesc)Debentures

Securities like Preference Shares and Debentures cannot be traded in the secondary market.

Equity shares is issued by the under writers and merchant bankers on behalf of the company.

Equity shares are tradable through a private broker or a brokerage house.

People who apply for these securities are: a)High networth individualb)Retail investorsc)Employeesd)Financial Institutionse)Mutual Fund Housesf)Banks

Securities that are traded are traded by the retail investors.

One time activity by the company. Helps in mobilising the funds for the investors in the short run.

Components of Indian Financial System

1. Financial institutions2. Financial Markets3. Financial Instruments/Assets/Securities4. Financial Services.

Indian Financial System

International Financial Market

Financial Markets Foreign Exchange and Eurocurrency market

Domestic and International Bond Market

Domestic and International Stock Markets

Derivatives Markets

Important Characteristic of Financial Markets

Liquidity: The ease of capturing an asset’s value

Reflects a market’s operational efficiency

Impacts a market’s informational and allocational efficiency

The inter bank foreign exchange market for large transactions is the world’s most liquid market

Other Market Characteristics

Maturity: Short-term: Money market Long-term: Capital market Regulatory Jurisdiction: Single-country internal markets Multi-country external markets Middlemen Intermediated through a commercial bank Non-intermediated or direct to the public,

through a broker or investor bank

Foreign Exchange Markets conducted through commercial

banks

Spot Market Cash market with delivery in two

business days Forward Market Trade at a prearranged date and

price

Intermediated Markets in bank deposits and loans

Money Markets Capital Markets

Internal Markets

Short term accounts with domestic clients

Long term accounts with domestic clients

External markets

Eurocurrency deposits and loans

Long term accounts with foreign clients

Non-intermediated (Direct) markets

Money Markets Capital markets

Internal Markets

Short term Commercial Paper

Stocks and bonds issued in the domestic market

External markets Eurocommercial paper

Global equity, foreign bonds and Euro bonds

Eurocurrency Markets Eurocurrencies: Bank deposits and loans

residing outside any single country Floating rate pricing usually with

maturities less than five years Few regulatory restrictions because

they are outside the jurisdiction of any single government

Competitive pricing – outstanding in 2.5 trillion dollars

Few regulations in eurocurrency market

Typically there are No reserve requirement No interest rate regulations or caps No with holding taxes No deposit insurance requirements No credit allocation regulations Less stringent disclosure

requirements

Floating rate pricing in eurocurrency market

Low interest rate risk: Interest rates tied to a variable rate base such as the LIBOR

Low default risk: Traded between large commercial banks, investment banks and multinational corporations

Relatively short maturities: Typically less than five years

Global Equity offerings Cross listing of shares: Increase

demand and enhance share price, Improves image of the firm, Gets more customer and investor base

Cross listing benefits the firm in improving transparency and disclosure, reduces opportunity for hostile takeover.

Dominant: 56 per cent

International Bond Market

Domestic Bonds Foreign Bonds Euro Bonds: Samurai, Bull dog, Yankee

USA dominant: 31 per cent

Derivatives Market Forwards Swaps Options Futures