Financial System

Circular flow of money

Functions of the financial system
Financial Assets
Financial Markets
o Classification of Financial Markets
o Nature of claim
o Maturity of claims
o Primary and Secondary
o Timing of delivery
Financial Instruments:
o Classification of financial instruments in the money market
o Negotiale certificates of de!osit "NC#s$:
o %overnment stock and other short&term interest rate instruments
'ankers( acce!tances
Treasury Securities
Commercial paper and other discount instruments
Financial Intermediaries
o Commercial 'ank
o Investment ) #evelo!mental Financial Institutions
o Insurance Com!anies
o Mutual Funds
o Non&'anking Financial Com!anies "N'FCs$
o *ther Financial Institutions
+egulatory infrastructure
o The Fed,s Structure:
Ma-or Functions of Federal +eserve
o Securities and Exchange Commission (SEC)
*-ectives of S.C
Circular Flow of Money
Susan is em!loyed as an .ngineer in California/ A !ortion of her salary from the Com!any is !aid
ack to the %overnment in the form of ta0es/
1hen the City of California receives those ta0 dollars2 they hire Innovative Inc to lay o!tic fire
cales within the California city limits/ This hel!s Susan communicate etter with her clients/
1hen Innovative Inc gets the contract to lay the cales2 they hire a new worker2 3oe Simon who
has een unem!loyed4 3oe is now eing !aid reasonale wage/ 5e anks some of his salary at
#ouche 'ank and gives some to his son2 Arthur Simon/
Arthur Simon is now ale to uy those new Nike designer oots he(s een wanting since they
ecame a fad at school/
Meanwhile2 Innovative Inc has een ale to orrow some money from new de!osits recently
made at #eustche 'ank/
Innovative Inc is ale to e0!and2 increase its !rofits2 and !ay more ta0es/
1hen the City of California receives this new ta0 revenue2 it increases !olice !atrols in the city
that makes it less likely that Innovative Inc2 the Simon family2 and #ouche 'ank will e victims of
crime/
.veryone is2 therefore2 ha!!ier and more secure/ They are also more !roductive and this leads to
more s!ending that leads to more -os that leads to increased incomes and ta0 revenues that
leads to more s!ending that leads to more -os that leads to increased incomes and ta0 revenues
that leads to more s!ending that leads to more -os that leads to more / / / and so on/
This is how the circular flow of money works in an economy/
An economy consists of two markets the !roduct market and the factor market which is also
referred to as the in!ut market/ These two markets are connected through usiness and the
household sector/
In !roduct markets2 consumers uy goods and services that are !roduced y !rivate usinesses/
For e0am!le2 students uy food2 clothing2 noteooks2 !a!er2 automoile insurance2 and watch
movies at the theatre/
Consumers s!end income to !urchase these goods and services/
'usinesses !roduce goods and services to sell in the !roduct markets/
'usinesses receive revenues for the sale of their goods and services/
5ouseholds !rovide laor and other factors of !roduction to usinesses in factor markets/
5ouseholds receive income for the factors of !roduction that they !rovide/ In e0change for work2
they e0!ect to receive !ayment in the form of wages or salaries/
'usinesses have costs of !roduction for the laor and other factors of !roduction they em!loy/
'usinesses !ay ta0es on their !rofits/ 'usinesses !ay ta0es to federal2 state2 and local
governments/
%overnments !rovide !ulic goods that facilitate usiness o!erations2 such as fire and !olice
!rotection2 roads2 and the legal system/ %overnments use some of the ta0 revenue collected to
!roduce goods and services/
%overnments make welfare !ayments and !ayments to memers of the armed forces and other
government em!loyees/
5ouseholds !rovide laor skills in the government/ In e0change for the work they do as
government em!loyees2 workers e0!ect to receive !ayment in the form of wages or salaries/
5ouseholds !ay income2 sales2 and !ro!erty ta0es/
%overnments !rovide !ulic goods such as education2 !ulic health services2 and !arks/ These
!ulic goods are used y households/
5ouseholds save !art of their income in financial institutions/ Saving is income that isn(t s!ent on
current consum!tion or ta0es/ 5ouseholds earn interest on their savings/
'usinesses orrow money from financial institutions/ Financial institutions lend money that is on
de!osit to usinesses/ 'usinesses use this money to invest in ca!ital goods with which they may
uild new factories or uy new tools and e6ui!ment/ 'usinesses !ay interest on these loans/
The financial system of an economy consists of
s!eciali7ed and non&s!eciali7ed financial institutions2
organi7ed and unorgani7ed financial markets
financial instruments and services which facilitates transfer of funds/
Financial System
Financial system com!rises of a variety of markets2 intermediaries and instruments that
are systematically related/ It !rovides the mechanism for transforming the savings into
investments and eliminates information asymmetry/ It is necessary that the financial
system work efficiently for the !ro!er allocation of resources in an economy/
Demanders of Funds
Individuals
Businesses
Governments
Financial Institutions
Banks, Insurance
Companies, Mutual
Funds, rovident !unds,
"on#$anking !inancial
Institutions
Supplier of Funds
Individuals
Businesses
Governments
Financial Markets
Mone% Market
Capital Market
rivate
lacement
Funds
Funds
&eposits'shares
(oans
Funds Funds
Securities Securities
Funds
Securities
The functioning of the financial system is characterised y an inter!lay of 8su!!lier of
funds, and 8demanders of funds, facilitated y financial intermediaries and financial
markets/ The financial intermediaries are 'anks2 Insurance Com!anies2 Mutual funds2
Provident funds2 who moili7e savings and hel!s in the formation of ca!ital2 whereas the
financial markets are the !lace where the financial assets are e0changed/
Illustration:
Mr.Roger, CEO of Innovative Inc, is in need of funds for expansion. He has two
alternatives.
Approach a Financial Institution.
Raise Mone in the Capital Mar!et.
Morgan "tanle, the financial institution that he approached was not convinced a#out
financial sta#ilit of Innovative Inc and as!ed for a credit rating of Innovative Inc. Mr
Roger therefore su#$ected co%pan to the scrutin # CARE a credit rating agenc.
&hen, Morgan "tanle agreed to provide part of the finance provided his co%pan is
listed in the '("E. &his re)uires that Innovative raises re%aining %one fro% the Capital
Mar!et, through an Initial *u#lic Offiering +I*O,.
Credit "uisse agreed to underwrite the loan and Innovative co%pleted its pu#lic issue
successfull. &he re)uire%ent of funds was %et.
&he entire process of see!ing and availing funds constitutes a transfer of surplus funds
fro% the household sector to the #usiness sector which has #een facilitated # the
financial institutions such as Morgan "tanle, CARE and Credit "uisse and financial
%ar!ets.
&his is how the financial sste%s helps in the transferring of funds fro% the people with
surplus funds to those in need of funds.
All usinesses have to constantly address 6uestions such as:
9 1hat is the ca!ital investment that I should make:
9 1here will I raise the money: and
9 1hat will e the est mi0 of e6uity and loans:
These are the three road areas of financial decision making2 technically referred to as
Ca!ital Structure2 Ca!ital udgeting and 1orking Ca!ital Management/
The overall goal of financial management is to ma0imise the shareholder value of a
com!any/
As a finance manager you have to serve as the interface etween the firm and the
financial system2 since you have to negotiate loans from financial institutions2 raise
resources from financial markets and invest sur!luses in these financial markets/ ;ou
will e e0!osed to the conce!tual framework for understanding how the financial system
works/ The main to!ics to e covered to understand the working of a financial system
are
Functions of the financial system
Financial Assets
Financial Markets
Financial intermediaries
+egulatory infrastructure
Functions of the financial system
%iven the nature of a financial system2 there could e an imalance in the distriution of
financial resources within a system/ These imalances can e over s!ace or over time/
This financial system !rovides a mechanism for the redistriution of these funds over
s!ace2 time2 across orders and among industries to even out the imalances/ #uring
the lean !eriod of a usiness2 the demand for funds will e slack whereas during the
!eak season2 the demand will e0ceed su!!ly/ A well&develo!ed financial system in an
environment of skewed distriution of resources hel!s in distriuting the resources
evenly/
The develo!ment of a financial system !aves the way for managing uncertainty and
controlling risk y offering a variety of financial tools to overcome the vagaries of the
usiness and the o!!ortunity for risk !ooling and risk sharing for oth households and
usiness firms/ The commonly used instruments for the management of risk are
hedging2 diversification and insurance/ 5edging hel!s in shifting from risky assets to risk
less assets/ A forward contract is a e0am!le of a hedging device/ #iversification of
assets does not eliminate risk ut only minimises it2 y s!reading the risk/ An investor
instead of investing in one stock and risking his investment s!reads the investment over
several stocks to minimise the risk of over e0!osure/ Insurance is a mechanism that
enales the insurer to overcome the losses y entering into an insurance contract with
an insurance com!any in return for an insurance !remium !aid to the insurer/
Information !lays a crucial role in decision&making/ <ack of information could lead to
disaster in any usiness/ A !erson without information could commit errors in decision&
making2 known as adverse selection/ <ack of awareness regarding a !articular ha7ard is
likely to affect usiness adversely/ An institution2 which identifies this event2 can offer this
information to the uninformed for a !rice/ The financial system thus hel!s in reducing the
information asymmetry and hel!s in coordinating decision&making/ For instance2 interest
rates and security !rices generated y the markets are used y households and firms in
making their consum!tion and savings decisions and in choosing the !ortfolio allocation
of their wealth/
Financial Assets
An asset is any !ossession that has value/ It can e tangile or intangile/ <and2
'uilding2 Machinery2 =ehicles2 and investments are tangile assets and intangile asset
re!resents a claim for future enefits like !atents2 co!y right2 goodwill2 rand name/
Su!!ose Pfi7er <td uys a >?&year government ond carrying @A interest2 for a
consideration of BCD millions/ The ond constitutes a tangile asset in the ooks of
Pfi7er <td/ Similarly2 the investment on machinery2 uildings2 etc are tangile assets of
the com!any/
Pharmacia <td/ uys the !atent of a molecule for a drug from Pfi7er <td for a
consideration of BC? million/ This right to manufacture the drug is an intangile asset that
could e sold for a consideration2 if Pharmacia <td/ wishes/
Classification of Financial Markets
Markets can e classified into different categories de!ending on the characteristic of the
market or instrument/
Nature of claim: Markets are categorised into det markets and e6uity markets ased
on the nature of the claim on the investment/ #et market deals with securities2 which
have a fi0ed claim and are redeemed on a fi0ed date and the interest is fi0ed/ For
e0am!le2 onds2 deentures2 fi0ed de!osits etc/ are the instruments in a det market/
The e6uity market is the financial market where shares of com!anies are traded/ The
values of the e6uity shares re!resent the net worth of the com!any2 which is referred to
as the residual claim of e6uity instruments/
Maturity of claims: 'ased on time for maturity financial instruments are of two ty!esE
short term and long term/ The money market deals with short term instruments for
e0am!le treasury ills and short term onds/ The ca!ital market deals with long term
det and e6uity instruments2 such as deentures and shares/
Primary and Secondary: New issues made directly to the investors is called !rimary
markets and the market where e0isting securities are traded is called secondary
markets/
Timing of delivery: Instruments where the date of transaction and the date of e0ecution
of the transaction are different2 are classified into:
S!ot Market: where2 the closing of the transaction and the delivery of the goods take
!lace simultaneously or within a short s!an/
Forward Market: The forward market is the market where a transaction is closed in the
!resent2 and the settlement of the transaction and the delivery of goods are in the future/
The delivery date and the !rice are determined at the closing of the transaction/
Is a $rand name an asset o! a compan%)
"ot until it is valued*
Financial nstruments:
Financial Instruments facilitate the transfer of funds from the su!!lier to the orrower/
An intermediary seeks to address the different needs of the orrower and su!!lier
through negotiations and financial instruments/ A certificate would e issued to the
lender2 giving him the right to interest !ayments and the !rinci!al amount at the time at
its e0!iry date/ This certificate is called security/ <arge financial transactions involving the
lending and orrowing of money2 which are done through intermediaries2 are often
structured and standardised regarding:
the amount of the loan or investment
the interest !aid and received thereon
the !eriod of redem!tion of the loan/
these standards created for transactions are incor!orated into financial instruments2 in
order to enhance the marketaility and tradaility of these securities2
1here Morgan Stanley orrows money and gives the lender "investor$ a certificate
!romising to !ay him B>?? thousand2 on > 3une C??D and interest of >>2??A !er annum2
is an e0am!le of a financial instrument called F!romissory noteG2 re!resenting the
+re the stock markets a primar% market !or securities)
,he stock market is a market o! secondar% sale o! stocks and securities and there!ore
it is a secondar% market and not a primar% market*
"ature o! Claim
Maturit% o! claim
rimar% and Secondar%
,iming o! &eliver%
&e$t market
E-uit% market
Mone% market
Capital market
rimar% market
Secondar% market
Cash or spot market
For.ard market
contract etween the lender and orrower/ Instruments like deentures issued y a
com!any are called F!rimary securitiesG/ Instruments like long term onds issued y
intermediaries like a ank or a government on ehalf of the ultimate orrower are called
Findirect securitiesG/
Classification of financial instruments in the money market
There are asically two ty!es of instruments issued and traded in the money market2
namely:
Instruments which !ay interest on the amount invested2 where the interest is
normally !aid to the holder of the instrument "the lender$2 together with the
redem!tion amount on the date of redem!tion/ Interim interest !ayments may e
made in certain cases/ These instruments are called interest instruments/
Instruments in this category include:
& Negotiale certificates of de!osit "NC#s$
& Short&term government securities
& Interest rate instruments issued y the !rivate sector2 with terms to
maturity of less than three years/
Instruments that do not !ay interest on the amount invested2 ut are issued at a
discount on the nominal value "the redem!tion amount$/ These instruments are
called discount instruments/ Instruments in this category include:
& 'ankers( acce!tances "'As$
& Treasury ills "T's$
# Commercial !a!er
Negotia!le certificates of deposit "NC#s$:
A negotiale certificate of de!osit is a certificate issued y a ank for a de!osit made at
the ank/ This de!osit attracts a fi0ed rate of interest2 which is normally !ayale to the
holder of the instrument together with the nominal amount invested2 at redem!tion date/
NC#s are earer documents2 which means that the name of the owner "holder or
de!ositor$ does not a!!ear on the document/ The earer or holder of the document will
receive the maturity value at maturity date/
,he discount rate o! the treasur% $ill is a re!lection o! the demand and suppl% position
o! short term !unds*
/es* &iscount rates o! treasur% $ills is determined $% demand and suppl% o! short term
!unds*
.0am!le:
The maturity value of an NC# will e the nominal amount de!osited !lus the interest for
the !eriod/ If for instance a de!osit of B> Million is made on > March for a !eriod of D
years2 and interest !aid on the amount is HA2 the maturity value is calculated as follows:
Nominal amount B >??????
Interest B I@JKCH
Maturity =alue B >I@JKCH
The holder can sell the instrument to another !arty efore the redem!tion date/
+ememer that financial instruments are traded etween !arties on a yield to maturity
"e0!ressed as an interest rate$ asis2 ecause interest is the !rice that is !aid for money
orrowed/ The uyer will e the new holder2 and he may !resent the NC# to the ank on
redem!tion date to receive the maturity value of BI@JKCH or sell it in the secondary
market !rior to maturity/
%overnment stock and other short&term interest rate instruments
%overnment stock and other !rivate sector instruments are normally issued for long&term
!eriods with more than one interest !ayment efore redem!tion/ 1here the term to
redem!tion of a government stock or other interest rate instrument for short term in the
money market category/
'ankers( acce!tances
A ankers( acce!tance is also called as 'ill of .0change/ It was invented to suit the
needs of a !arty re6uiring tem!orary finance to facilitate the trading of s!ecific
goods/ The !arty needing finance would a!!roach investors for this tem!orary
finance/ The investors or lenders would then lend a certain amount to the orrower in
e0change for a document called 'ill of .0change2 stating that the det would e !aid
ack on a certain date in the short&term future/ For this arrangement to e attractive to
the lender2 the amount !aid ack y the orrower "called the nominal amount$ would
have to e more than the amount advanced y the lender/ The difference etween the
amount advanced and the amount !aid ack "the nominal amount$ is known as the
discount on the nominal amount/ The two !arties would normally e rought together y
a ank/
The redem!tion of the loan would have to e guaranteed y a ank2 called the
acce!tance y the ank making the arrangement/ Thus the name Lankers(
acce!tanceL/
The earer of the document may2 at the redem!tion date a!!roach the ank who will !ay
the nominal amount to the holder/ The ank will then claim the nominal amount from the
orrower/
A ank acce!tance can2 in formal terms2 can e descried as an unconditional order in
writing
addressed and signed y a drawer "the lender$
to a ank which signs the document and ecomes the acce!tor
!romising to !ay a certain amount of money at a fi0ed date in the future
to the earer or holder "the orrower$ of the document "the acce!tance$/
.0am!le
Since there is theoretically no interest !ayale on a ankers( acce!tance2 the investor
would want to !ay less than the nominal amount for the acce!tance in order to receive a
certain yield on his investment when2 at redem!tion2 he receives the nominal amount
from the orrower/ The rate 6uoted on a ank acce!tance is the rate of discount on the
nominal amount of the acce!tance that is used to calculate the amount advanced y the
lender/ The rate is given as an annual rate/
In the following e0am!le a 'A "ank acce!tance$ is issued at >CA/ The nominal
amount of the 'A is B > Million and it is issued for J? days/
The discount on this 'A would e worked out as follows:
#iscount M N 0 d)K@D 0 di)>??
where
N M nominal value
# M Tenure in days
di M discount rate as a fi0ed amount
In this case
#iscount M B>?????? 0 J?)K@D 0 >C)>??
M BCJDHJ
The !roceeds which the orrower "drawer$ would get at issue date2 which is e6ual to the
amount that the investor or lender would !ay would e:
Proceeds M nominal amount & discount
In this case
Proceeds M B>?????? & BCJDHJ
M BJN?I>>
If the investor needs his money efore the redem!tion date2 this 'A maye sold in the
market to another investor who would then ecome the new lender/ This can e done
ecause the 'A is a earer document/
Treasury Securities
The government issues treasury ills/ They are discount instruments issued for the short
term2 similar to 'As/ The issue and redem!tion of these instruments are handled y
Central 'ank on ehalf of the government/ Treasury ills are issued in earer form2 and
the earer or holder of the instrument may !resent it for !ayment of the nominal amount
at redem!tion date/ The Central 'ank would normally !ay this amount into the holder(s
current ank account on the redem!tion date/
1eekly treasury ills are issued and allocated on a tender asis/ These ills have a
tenor of J> days and are allocated to interested !arties who sumitted tenders on these
ills/
.0am!le:
'efore a !arty will tender for a ill2 he has to decide on the discount rate that he would
like to earn on his investment/ This rate will !roaly e market related and not far from
the ruling 'A rate/
If2 for instance2 a !arty decides on a discount rate of >CA on his investment2 the tender
!rice that he would sumit on J>&day treasury ills would e:
Price M >?? & "di 0 d)K@D$
where
di M discount rate the !arty wants to earn e0!ressed as a fi0ed amount
d M tenure in days
In the aove e0am!le the tender !rice sumitted will e:
Price M >?? & ">C 0 J>)K@D$
M JN2??H
In the calculation of the discount2 !roceeds and consideration if sold !rior to redem!tion
date2 the same formula as that used for the 'A can e used/
Commercial !a!er and other discount instruments
Commercial !a!er refers to short&term unsecured !romissory notes normally issued y
cor!orate com!anies with a high credit rating/ These instruments are also issued on a
discount asis such as 'As/ 'ecause they are unsecured2 the risk involved will e
higher than that of 'As2 and therefore the issuing institution must e financially strong
and sound/ 'ecause of the risk attached to these instruments they would normally e
issued and traded at a higher discount than the !revailing 'A rate/
Finance can e otained y making use of various alternative kinds of discount
instruments/ *ther discount instruments that have een used are secured !romissory
notes and asset acked commercial !a!er/ The Central 'ank also issue discount ills
from time to time/ It is thus clear that finance2 using money market instruments2 can e
arranged etween !arties over the counter2 as needs e/ Standardised instruments as
discussed aove are more li6uid and tradale/
Financial ntermediaries
Financial intermediaries are firms that !rovide financial services and !roducts/ They
facilitate the o!eration of financial markets !ooling research and e0!ertise together with
scale economies/ .0am!les are anks2 insurance com!anies2 mutual funds2 investment
anks/ These intermediaries are needed to match different financial needs such as the
need to orrow and the need to invest/ Another e0am!le of financial intermediary is a
mutual fund which !ools the financial resources of many individuals and invest it in a
asket of securities/ It has a advantage of economies of scale in conducting research
and identifying investale stocks/ 5ence2 it offers its customers a more efficient way of
investing than they could individually/
The structure of the financial intermediaries is de!icted elow:
Intermediaries are im!ortant ecause they
+educe transaction costs
5el! in achieving .conomies of scale
5el!s in overcoming Asymmetry in information
5el!s to *vercome Moral ha7ards
Commercial %ank: Commercial anks com!rise !ulic sector anks2 foreign anks2
!rivate sector anks and re!resents the most im!ortant financial intermediary in any
financial system/ These institutions have a wide geogra!hical s!read and dee!
!enetration and strong de!osit moili7ing aility/ 'ank credit is !rovided to all sectors of
the economy and the rural sector is accorded !riority/ They !lay very im!ortant role in
the money market and !lay a vital role in the call money market/
nvesetment & #evelopmental Financial nstitutions: The develo!mental financial
institutions !rovide the long&term financial needs of cor!orations/ These institutions have
een res!onsive to the growing and varied long term ca!ital needs of economy/ Their
wide range of activities may e divided into five road categories2 "i$ direct financing2
"ii$ indirect financing2 "iii$ assistance financing2 "iv$ !romotional work2 and "iv$
miscellaneous activities/ .0am!les of investment financial intermediaries are: Chase
Manhattan Cor!oration2 Credit Suisse First 'oston2 Aurey %/ <anston O Co/ etc/
nsurance Companies: Insurance com!anies !rovide life and !ro!erty risk y collecting
!remium/ This !remium is invested in oth short and long term securities to earn !rofits/
Mutual Funds: Mutual fund is a collective investment arrangement/ There are three
entities in a mutual fund2 the s!onsor2 the trust and the asset management com!any/
The s!onsor !romotes the mutual fund/ The mutual fund is organi7ed as a trust
managed y oard of trusties/ This trust acts as an umrella organi7ation which floats
various schemes2 in which the investing !ulic can !artici!ate/ The asset management
com!any is organi7ed as a se!arate -oint stock com!any which manages the funds
moili7ed under various schemes/
Non'%anking Financial Companies "N%FCs$: N'FCs engage in a variety of fund
ased and non&fund ased activities/ The !rinci!al fund ased activities are leasing2 hire
!urchase2 ill discoutingP and the non&fund ased activities are merchant anking2
cor!orate advisory services2 loan syndication and fore0 advisory services/
Commercial
Banks
Investment/
Developmental
Financial
Institutions
Insurance
Companies
Mutual
Funds
NBFCs
Central Bank
Other
Organiations
Merchant $anks,
0enture capital
and in!ormation
services
(ther Financial nstitutions: Merchant anks2 venture ca!ital firms and information
services are some of the other financial institutions/ Merchant anks are firms which hel!
usiness2 government and other entities raise finance y issuing securities/ They also
facilitate merger and ac6uisitions and derivatives/ =enture ca!ital firms are somewhat
similar to merchant anks as they assist start&u! firms/ ;oung firms with limited ca!ital
and managerial e0!ertise re6uire resources and advice in running their usiness/
=enture ca!italists !rovide managerial su!!ort as well as ca!ital/
Information Services: Many financial service firms !rovide information as su!!lementary
services/ The well&known firms !roviding financial services are Credit +ating Agencies
like C+ISI<2 CA+. and IC+A and ca!ital market information services like Proity
+esearch and QPM%/
)egulatory infrastructure
A regulatory mechanism is needed to regulate the working of the financial system/ Its
main function is to control com!liance according to the regulations of the Central 'ank2
commercial anks2 financial institutions2 insurance com!anies2 non anking financial
institutions2 e0change houses and official credit institutions2 it is also res!onsile for their
su!ervision/ It also ins!ects and su!ervises issuers registered in the Pulic Stock
+egistry/ It also su!ervise com!liance with the dis!ositions a!!licale to the Pension
Savings System and Pulic Pension System2 and es!ecially administrative institutions
for Pension Funds2 the Pulic .m!loyee Pension Institute and the Social Security(s
#isaility2 *ld Age and #eath Program/
The Federal +eserve and the Securities .0change Commission"S.C$ are the two
im!ortant agencies2 res!onsile for regulating the money and ca!ital markets/
The Fed*s Structure:
Federal +eserve refered to as 8Fed,/ It is an inde!endent organi7ation created y
Congress to maintain the value of money and the financial health of the system/ The
seven&memer 'oard of %overnors is the main governing ody of the Federal +eserve
System/ The 'oard is charged with overseeing the >C #istrict +eserve 'anks and with
hel!ing im!lement national monetary !olicy/ %overnors are a!!ointed y the !resident of
the Rnited States2 one on 3anuary K> of every even&numered year2 for staggered >I&
year terms/ The chairman and vice chairman of the 'oard of %overnors are also
a!!ointed y the !resident and confirmed y the Senate to serve a four&year term/ The
nominees of these !osts are selected from the 'oard memershi!/
Ma+or Functions of Federal )eserve are:
>/ to conduct the nation,s monetary !olicy2
C/ to !rovide and maintain an effective and efficient !ayments system2 and
K/ to su!ervise and regulate anking o!erations/
Currency and Coin: .nsuring enough currency and coin in the economy/
*!en Market *!erations: 'uying and Selling R/S/ %overnment securities in the o!en
market to staili7e short&term interest rates/
#iscount +ate: Fi0es the discount rate that Federal +eserve charge financial institutions
for short&term loans of reserves/
The +eserve +e6uirement: Fi,es the reserve re6uirement which is the !ercentage of
demand de!osits that financial institutions must hold in reserve/
The 'anker,s 'ank: Fed !rovides services to financial institutions in much the same way
commercial anks serve their customers/
Automated Clearing 5ouse: Federal +eserve o!erates automated clearinghouse system
to handle !ayments/ For larger transactions2 deits and credits are usually transferred
electronically through Fedwire2 a highly so!histicated2 com!uteri7ed communications
network that transfers funds almost instantly from one de!ository institution to another
anywhere in the country/
The %overnment,s 'ank: Fed +eserve serve as ank for the %overnment y maintaining
accounts2 !roviding services for the Treasury and y acting as de!ositories for federal
ta0es/
'anking Su!ervision: The Federal +eserve has su!ervisory and regulatory authority
over a wide range of financial institutions and activities/
The <ender of <ast +esort: Through the Fed(s discount and credit o!erations2 it !rovide
li6uidity to anks to meet short&term needs stemming from seasonal fluctuations in
de!osits or une0!ected withdrawals/
International Services: Federal +eserve !erforms services for foreign central anks and
for international organi7ations/
Securities and -,change Commission "S-C$
The Securities and .0change Commission "S.C$ su!ervises and hel!s in develo!ing
ca!ital market of the country/
The S.C su!ervise the ca!ital market in the five main areas:
"a$ estalishing asic financial infrastructure and institutions for market develo!ment
"$ laying down rules2 regulations2 and legal framework2
"c$ roadening o!!ortunity for !rivate sector to o!erate securities usinesses2
"d$ su!ervising and e0amining securities usinesses2 and ca!ital market and
"e$ !romoting international relations
(!+ectives of S-C
>$ To maintain market fairness y creating e6ual and uniased disclosure of information
for investors/
C$ To enhance efficiency of the ca!ital market/
K$ To maintain long&term staility of the financial system/
I$ To strengthen international com!etitiveness of the ca!ital market/
S.MMA)/
9 The financial system consists of a variety of institutions2 markets and
instruments/ It !rovides the means of transforming savings into investments/
9 Financial system !rovides !ayment mechanism2 enales !ooling of funds2
facilitates management of uncertainity2 generates information for decision making
and hel!s in dealing with information asymmetry/
9 Financial markets are markets where financial assets are e0changed/ The
financial markets !lay a very im!ortant !art in the working of an economy/
9 Financial Markets facilitates !rice discovery2 !rovides li6uidity and reduces the
cost of transaction/
9 The im!ortant asis of classifying financial assets are ased on ty!e and maturity
of claims2 fresh and outstanding issues and nature of delivery/
9 The market for securities issued for the first time is called a !rimary market and
market where instruments are traded suse6uent is called the secondary market/
9 The money market deals with instruments of short term securities2 whereas the
ca!ital market deals with long term det or e6uity instruments/
9 Financial intermediaries are the firms that engage in !roviding services and
!roducts/ They facilitate the o!eration of the financial markets/
9 Financial intermediary seek to merge needs and demands of orrowers and
lenders through negotiations of financial instruments/
9 The Central 'ank regulates the functioning of the financial intermediaries and
formulates the monetary !olicy of the country/ The Securities .0change
Commission su!ervises the working of the ca!ital market and its constituents/