Management of Financial Services

Introduction to Indian Financial System

A financial system plays a vital role in the economy growth of the country

It intermediates between the flow of funds from those who save a part of their income and those
who invest in productive assets

It mobilizes and allocates scarce resources of a country

A financial system is a set of sub-systems of financial institutions, markets, instruments and

services which facilitates the transfer and allocation of funds efficiently and effectively

Characteristics of a Financial System

A Financial system is characterised by the coexistence and co-operation between the formal and
informal financial sectors.

The coexistence of these sectors is known as financial dualism

The formal sector is characterised by the presence of an organised, institutional and regulated
system catering to the financial needs of the modern spheres of the economy

The informal sector is an unorganised, non-institutional and unregulated system dealing with the
traditional and rural spheres of the economy

The informal sector has emerged due to the restriction on access to financial needs of certain
deprived sections of the society

The advantages of the informal system are low transaction cost, minimal default risk and
transparency, though interest rates vary widely and tend to be higher

The informal system consists of individual money lenders, groups operating as funds or
associations

Partnership firms consisting of local brokers, pawnbrokers and non-bank financial intermediaries
such as finance, investment and chit-fund companies

The formal system comes under the purview of the Ministry of Finance, RBI, SEBI etc

The formal system has spread wide and grown exponentially with the spread of rural banking

Components - Financial System

Financial Institutions

Financial Markets

Financial Instruments and

Financial Services

Financial Institutions

They are the intermediaries that mobilize savings and facilitate the allocation of funds efficiently

These are banking and non-banking financial institutions

Banks are creators and suppliers of credit

Non-banking institutions such as development financial institutions (DFIs), non-banking finance

companies (NBFC) and housing finance companies (HFC) are the major suppliers of credit

FIs can also be classified as term-finance institutions; IDBI, ICICI, IFCI, SIDBI and Industrial
Investment Bank of India (IIBI)

Specialized FIs like EXIM Bank, Tourism Finance Corporation of India (TFCI), ICICI Ventures,
IDFC, NABARD and NHB

Investment institutions such as UTI, public and private sector MFs, LIC, GIC and its subsidiaries

State level financial institutions such as SFCs and State Industrial Development Corporations

Financial Markets

Financial markets are a mechanism enabling participants to deal in financial claims

They also provide a facility in which their demands and requirements interact to set a price for
such claims

The main organised financial markets are the money market, the capital market and the
derivatives market

Financial markets can also be primary and secondary

The secondary market can be OTC or exchange traded markets

An important component of a financial system

A mechanism for the exchange trading of financial products under a policy framework

Financial Markets comprise of the money market and the capital market

Money Market: short term debt instruments

Capital Market: long term debt and equity instruments

Segments of Financial Markets:

primary - for new issues

secondary - for trading outstanding issues

a buoyant secondary market is indispensable for the presence of a vibrant primary cap market

the secondary market provides a basis for the determination of prices of new issues

depth of the secondary market depends on the primary market

bunching of new issues affects prices in the secondary market

Characteristics

Large volumes, speed and mobility of funds across markets

Various segments such as stocks, bonds, primary and secondary

Scope for instant arbitrage among markets/instruments

Highly volatile and susceptible to panic/distress selling

Dominated by financial intermediaries who take invest decisions/risks on behalf of depositors

Interlinked. A failure in one affects others

Domestic markets getting integrated with international markets

Functions

Enable economic units to exercise their time preference

Separate, distribute, diversify and reduce of risk

Efficient payment mechanism

Provide company information

Transform financial claims to suit the preference of savers and borrowers

Enhance liquidity of financial claims through trading in securities

Provide portfolio management services

Financial Instruments

Is a claim for payment at a future date of a sum of money and/or a periodic payment in the form
of interest or dividend

They represent paper wealth - shares, debentures, bonds and notes

Many of these instruments are marketable as they are denominated in small amounts and traded
in organised markets

This enables investors to hold a portfolio of different financial assets which helps in reducing risk

Savings and investments are linked through various instruments called securities

Financial securities are financial instruments that are negotiable and tradable

Financial securities may be primary or secondary securities

Primary (direct) securities (shares and debentures) are issued by the ultimate borrower to the
ultimate saver

Secondary (indirect) securities (bank deposits, mutual funds and insurance policies) are issued by
financial institutions to the ultimate saver

Financial instruments differ in terms of marketability, liquidity, reversibility, type of options,

return, risk and transaction costs

Financial instruments help financial markets and financial intermediaries channelise funds from
lenders to borrowers

Availability of different financial instruments help financial intermediaries improve their risk
management

Financial Services

Help with borrowing and funding, lending and investing, buying and selling securities, making
and enabling payments and settlements and managing risk exposures in financial markets

The major categories of financial services include financial intermediation, payment mechanism,
provision of liquidity, risk management and financial engineering

Financial Intermediating services link the saver and the borrower which in turns leads to capital
formation.

Payment services enable quick, safe and convenient transfer of funds and settlement of
transactions

Liquidity is essential for smooth functioning of a financial system. Financial liquidity of financial
claims is enhanced through trading in securities

Financial services enable risk transfer (from those who do not want it to those who accept it) and
protection from risk (exchange rate and interest rate)

Financial engineering presents opportunities for value creation. They refer to the process of
designing, developing and implementing innovative solutions for needs in funding, investing
and risk management

Banks, insurance companies, mutual funds and stock exchanges provide these financial services

Merchant banking, leasing, hire purchase and credit rating are some of these services

They bridge the knowledge gap among the investors and increasing sophistication of markets
and instruments

Functions of a Financial System

Link savers and investors thereby help mobilize and allocate savings efficiently and effectively

Monitor corporate performance

Provide payments and settlement systems

Optimum allocation of risk - bearing and reduction

Disseminate price related information

Offer portfolio adjustment facility

Lowers transaction cost

Promote the process of financial deepening and broadening

Key Elements of a Financial System

A strong legal and regulatory environment

Stable money

Sound public finances and public debt management

A central bank

A sound banking system

An information system

A well-functioning securities market

The Financial System and the Economy

Types of Economic units

Macro economic framework analysis

National Income Accounts

Flow of Funds Analysis

Trends in Savings and Investment

Types of Economic Units

Surplus spending economic units: are units whose income is greater than their consumption and
planned investments. The surplus savings are held either in cash balances or financial assets.
They demand financial assets or supply loanable funds.

The household sector is a net surplus spending economic unit

Deficit spending economic units: are units whose consumption and planned investments exceed
their income. They have negative savings and they finance their needs either by borrowing or
decreasing their financial assets. Borrowing by deficit spending units creates a supply of financial
assets or demand for loanable funds.

The government and corporate sector are deficit spending units

Macro-Economic Framework

To understand the role of the financial system in the economy, some frameworks and concepts of
macro-economics are deployed.

The main tools of analysis are:

National Income Accounts

Flow of Funds Account

Trends in Savings and Investments

National Income Account

Extends the accounting concept to the economy as a whole.

National income accounts of the sector-of-origin reveal the contribution made by different sectors
of the economy to the national income and the portion of the national income they consume

Classification of the Economy

Primary sector: agriculture, forestry and logging, fishing and mining and quarrying

Secondary sector: manufacturing, construction, electricity, gas and water supply

Transport, communication and trade: transport, storage and communication, trade, hotels and
restaurants

Finance and real estate: banking and insurance, real estate ownership of dwellings and business
services

Community and personal services: public administration and defence and other sectors

Foreign Trade

The combined gross output of all the sectors of the economy except the foreign sector is called the
GDP

GDP is the sum total of the value-added output of all goods and services

GDP can be measured from the production side where it is the sum of the output of agriculture,
industry and services

When measured from the consumption side GDP equals the sum of private consumption,
government consumption, investments and net exports

Add to the GDP foreign income i.e. repatriated income, profits and loyalty from abroad and you
get GNP

Flow of Funds Account

Flow of Funds Account: the savings and investment process creates a flow of funds.

Flow of funds brings out patterns of financing economic activities and financial relations between
different sectors.

National Income Account combined with the flow of funds account form a framework for
describing the transfer of funds and supply and demand in the securities market

Helps identify the role of finance in the generation of income, savings and expenditure

Helps identify the influence of economic activities on financial markets

It is an important tool for financial planning and forecasting

It discloses the level, depth and nature of financial activities in the economy.

Trends in Savings and Investments

Trends in Savings and Investments: one of the basic influences of financial development on
growth is the savings and investment rate.

One of the roles of any financial system is to augment and channelise savings into productive
avenues for economic growth

Savings is the income that exceeds consumption while investment refers to investment in real
assets such as plant and machinery, construction and additions to inventories.

Savings and investments are flow concepts which refer to the addition of the stock of wealth.

Uses of Savings and Investments Concept

Analyse fluctuations in economic activity

Analyse process of economic growth and

Analyse the method of financing gross domestic capital formation

The household sectors savings is increasingly distributed between financial assets such as
deposits, shares, mutual funds and insurance policies rather than in the form of currency