1/13/2007

Introduction

The financial system comprises a variety of intermediaries,

markets, and instruments that are related.

The Financial System

It provides the principal means by which savings are

transformed into investments.

An understanding of the financial system is useful to all

Chapter 2

informed citizens, it is particularly relevant to the financial

managers.

By: Param Shah

Deposits/
Shares

Funds

Financial Institutions
_______________
Commercial Banks
Insurance Companies
Mutual funds
Provident funds
Non-Banking financial
companies

By: Param Shah

Funds

Financial
System

Loans
Financial
Institutions

Funds

Suppliers of Funds
______________
Individuals
Businesses
Governments

Private Placement

Funds

Regulatory

Intermediaries

Banking

Non-Banking

Funds

Securities

Securities
By: Param Shah

Demanders of Funds
_______________
Individuals
Businesses
Governments

Financial Markets
_________________
Money Market
Capital Market

NonIntermediaries

Financial
Markets
Others

Organized

Primary

Financial
Instruments
Unorganized

Secondary

Primary

Financial
Services

Short term

Secondary

Capital
Markets

Capital
Markets

Capital
Markets

Capital
Markets

Money
Markets

Money
Markets

Money
Markets

Money
Markets

Medium term

Long term

Securities
4

By: Param Shah

1/13/2007

Functions of Financial System

Financial Assets

Financial Assets are intangible assets as they represent claims

Payment System.

to future cash flows.

Pooling of funds.

The term financial asset, instrument, or security are used

Transfer of resources.

interchangeably.

Risk Management.

Debt vs. Equity Claims: A financial asset may entitle its

Price information for decentralized decision-making.

owner to a fixed amount or a varying, residual amount. In

the former case, the financial asset is called a debt security
and in the latter case it is known as equity security.

Some securities straddle both the categories, example
Preference Shares.

Dealing with incentive problem.

By: Param Shah

By: Param Shah

Financial Markets

A financial market is a market for creation and exchange of financial assets.

Financial Market Returns

Functions of Financial Markets:

Facilitate price discovery.

Provide liquidity.

Reduce the cost of transacting.

Interest Rates: An interest rate is a rate of return promised by the

borrower to the lender.

Classifications of Financial Markets:

Based on Type of financial Claim:

Rates of returns on Risky Assets: Interest rates represent promised

Debt Market

Equity Market

returns on debt instruments. However, many assets do not

promise a given return. The return from such assets comes from
two sources: Cash dividend and Capital Gain (or Loss).

Based on Maturity of Claim:

Money Market

Capital Market

Based on Claim Representing New issues or Outstanding Issues:

Primary Market

Secondary Market

Based on Timing of delivery:

Cash or Spot

Forward or Futures

Based on the nature of its organisation Structure:

Exchange-traded Market

Over-the counter Market

By: Param Shah

The first component is called the dividend income component (or

dividend yield) and the second component is called the capital
change component (or capital yield)
8

By: Param Shah

1/13/2007

Financial Market Returns (Cont.)

Financial Market Returns (Cont.)

Inflation and Real Interest Rate: To make meaningful economic

Determinants of Rates of Return:

comparisons over time, the prices of goods and services must be

corrected for the effects of inflation. A distinction has to be
made between nominal prices, or prices in terms of some
currency and real prices or prices in terms of purchasing power.

The general relationship between these rates is as follows:

By: Param Shah

Expected Productivity of Capital

Degree of Uncertainty about Productivity of Capital

Time Preferences of People

Degree of Risk Aversion

10

Equilibrium in Financial Markets (Cont.)

Equilibrium in Financial Markets

Supply and Demand for loanable funds and determination of interest

By: Param Shah

Supply and demand for securities and determination of prices

rates

11

By: Param Shah

12

By: Param Shah

1/13/2007

Financial Intermediaries in India

Interest Rates in India

Interest rates in India traditionally were highly regulated.

Reserve Bank of
India

However, recently in the wake of financial liberalization, most of these

rates have been substantially deregulated.

The key interest rates are as follows:

Developmental
Financial
Institutions

Commercial Banks

Repo Rate: It is the rate paid by the central bank (RBI) on its short term

borrowings from banks. Current Repo Rate: 7.25%

Bank Rate: It is the rate at which the Central bank lends to Banks. Currently:

6%

Treasury Bill Rate: It is the rate on money market instruments issued by the
Government of India. Currently:5.9%-7.7%

Prime Lending Rate: It is the rate at which banks lend, generally on one year
basis, to their prime borrowers. Currently it is: 10.25%-10.75%

10-year government bond rate: It is often taken as a representative of the
government borrowing rate. Currently it is: 8.0967%-8.6364%
13

Source: www.rbi.org.in , 13th January, 2007

14

Insurance
Companies

Other Public
Sector Financial
Institutions

Mutual funds

Non-banking
Financial
corporations

Public Sector

All India
Institutions

Life Insurance
Corporation of
India

POSB

Public Sector
Mutual Funds

Public Sector
Firms

Private Sector

State Level
Institutions

Private Sector
Insurance
Companies

NABARD

Private Sector
Mutual Funds

Private Sector
Firms

General Insurance
Corporation of
India

NHB

By: Param Shah

Regulatory Infrastructure

Rationale for Financial Intermediaries

The two major regulatory arms of GOI are the RBI and the SEBI.

Reserve Bank of India:

Diversification

Lower transaction Cost

It provides currency and operates the clearing system for the banks.

It formulates and implements monetary and credit policies.

It functions as the bankers bank.

It supervises the operations of credit institutions.

It regulates foreign exchange transactions.

It moderates the fluctuations in the exchange value of the rupee.

It seeks to integrate the unorganized financial sector with the

Economies of Scale

Confidentiality

Signaling

organized financial sector.

It encourages the extension of the commercial banking system in the

rural areas.

It influences the allocation of credit.

It promotes the development of new institutions
15

By: Param Shah

16

By: Param Shah

1/13/2007

Growth and Trends in the Indian

Financial System

Regulatory Infrastructure (Cont.)

Securities Exchange Board of India (SEBI):

Growth:

The following evidences prove that the IFS has shown
impressive growth in post-1950 era:

Regulate the business in stock exchanges and any other securities

markets.

Register and regulate the capital market intermediaries.

Emergence of a wide array of financial institutions to provide a

Register and regulate the working of mutual funds.

Promote and regulate self-regulatory organisations.

Prohibit fraudulent and unfair trade practices in securities markets.

Promote investors education and training of intermediaries of

variety of services.

Significant expansion of the network of commercial banks and

operations of financial institutions.

securities markets.

Prohibit insider trading in securities.

Regulate substantial acquisition of shares and takeovers of companies.

Perform such other functions as may be prescribed.

17

By: Param Shah

Introduction of a variety of schemes and instruments for

mobilizing savings.

Remarkable growth in the primary as well as the secondary

segments of the capital markets

18

Growth and Trends in the Indian

Financial System (Cont.)

Growth and Trends in the Indian

Financial System (Cont.)

The financial development of a country is commonly assessed in

Trends:

The statutory liquidity ratio applicable to commercial banks is being lowered.
Currently it is 25%

The ambit of market-determined interest rates is increasing and
correspondingly the domain of administered interest rates is shrinking. This is
accompanied by greater volatility in interest rates.

Financial intermediaries like IDBI, which traditionally had substantial access to
cheaper SLR borrowing, have to now rely more on the capital market.

In the regulation of financial markets and financial intermediaries, prudential
regulation and supervision are being emphasized and product and price controls
are being done away with.

The IFS is getting gradually integrated with the world financial system.

Financial innovation is gaining momentum. Options and futures have been
introduced in India.

terms of the following ratios:

Finance

Ratio: Reflecting the relationship between financial

development and economic development, this ratio is defined as:

Financial Interrelations Ratios: An indicator which shows the

relationship between the financial system and the funding of

investment, this ratio is measured as:

New Issue Ratio: Reflecting the extent to which the non-financial

sector directly finances investment, this ratio is defined as:

Intermediations Ratio: A measure of the proportion of financial

transactions which occur through financial institutions, this ratio is

expressed as:

19

By: Param Shah

By: Param Shah

20

By: Param Shah