P R A V I N M A N D O R A G R O U P T U T I O N S

FINANCIAL SYSTEM

Financial system comprises a set of sub systems of financial institutions, financial markets, financial
instruments and financial services which help in the formation of capital, provides a mechanism by
which savings are converted into investments.

A financial system may be defined as a set of institutions, instruments and markets which encourage
savings and channel them to their most efficient use.

A financial system is a complex, well-integrated set of sub-systems of financial institutions, markets,

instruments and services which facilitate the transfer and allocation of funds, efficiently and effectively.

Therefore, the main function of financial system is the collection of saving and their distribution for
industrial investment, thereby stimulating the capital formation and to that extent accelerating the
process of economic growth.

Characteristics of financial system :

1. It is a system : A system consists of a few components properly linked and co-ordinated with each
other in such a way that the all functions exactly as expected. Our body is a system consisting of
hundreds of organs all working in coordination with one another so that we can work properly. Similarly,
financial system comprises financial markets, financial institutions, financial instruments and financial
services so that the whole financial system works properly. If one of them does not function propertly, the
working of the whole financial system is affected.
2. It comprises of four components : The financial system has four components as we have seen above.
They all function in a coordinated manner, so that financial system works smoothly. If any of the two
financial markets, namely, money market or capital market is disturbed the whole financial system will
be disturbed.
3. Regulated by Various Authorities : In order to protect the interests the investors and to see that
financial system functions properly, regulatory bodies are established in every country. These regulatory
bodies work as watchdog. E.g. in India SEBI has been established to regulate the capital markets and
money markets. The Reserve Bank of India controls and regulates the functioning of financial
institutions like banks. The IRDA looks after the working of insurance companies.
4. Economic Growth : It is due to efficient and effective working of the financial system that savings of
people are channelised into industrial investments. This leads to economic growth. The financial
intermediaries work as link between savers & borrowers. Financial markets are developed to provide
short-term and long-term funds to industries which leads to growth of econpiny.

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FINANCIAL SYSTEM

ROLE OF FINANCIAL SYSTEM

1. Role as mobiliser of funds : The financial system mobilises savings of large number of people who
want to invest their savings and get returns. On the other hand there are persons who want funds to
carry on their activities like business enterprises. The financial institutions serve as a link between
savings and investment and allocate funds in an efficient manner.
2. Role as a facilitator: The financial system works as a facilitator of funds transfer from saver to
borrower. Stock exchanges play a significant role in this respect. Through fresh issues savers invest
their savings into securities of business enterprises. The securities issued are then traded on stock
exchange which imparts liquidity to investment.
3. Role as a risk-bearer : Risk means a chance of loss. This risk of investors is managed by the financial
services. E.g., mutual funds collect savings of small small savers and invest them in securities of variety
of business enterprises, so that if price of one security falls, it may be compensated by rise in other
securities or the impact of a fall in price of one or two securities may be insignificant. There are regulators
like SEBI who regulate and control the conduct of issues of securities and the intermediaries to protect
the interests of investors in securities. The RBI regulates money markets so that the interests of investors
of short term instruments are protected.
4. Role as provider of payment mechanism : The financial institutions like banks provides a mechanism
for payment for exchange of goods and services. As Prof. Bharti Pathak has written, An efficient
payment and settlement system contributes to the operating and allocation efficiencies of the financial
system and thus, overall economic growth. Payment and settlement systems serve an important role in
the economy as the main arteries of the financial sector.
5. Role as a provider of information: The financial system performs a very important function of providing
price-related information to the participants. This enables the investors to decide whether to invest their
savings in the security of a particular company, whether to disinvest his particular holding. Thus this
information helps investors to obtain necessary information with minimum cost. Besides the information
regarding valuation of their securities help management to decide whether they are working on the right path
in their objective of maximising shareholders' wealth.
6. Role as an Agent of Economic Growth : The financial system works as a link between savers and borrowers. Not
only that but they help in mobilising and optimising allocation of the savings in the economy. This would
lead to the rapid economic growth of the nation. Due to development of financial system, new development
have come into economy. E.g., merchant banking, mutual funds in private sector, dealing in derivatives,
control over markets and services by institutions like SEBI, IRDA etc.

FUNCTIONS OF FINANCIAL SYSTEM :

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 P R A V I N M A N D O R A G R O U P T U T I O N S
FINANCIAL SYSTEM

The main function of financial system is to serve as a link between saving and investments. In this
function, both financial markets and financial institutions as also financial instruments play an
important role. The functions of financial system may be described as follows :
1. It serves as a valuable link between saving and investment. It helps in mobilising and allocating the
savings efficiently and effectively. It channelises flow of savings into productive investment, thus
promoting the economic growth of the country. Number of intermediaries help in doing this function
effectively.
2. Selection of project to be funded is extremely important, as success or failure of the project depends
on its proper selection. If the project fails, the company may incur huge losses and funds borrowed
may not be repaid. Financial system helps in selection of project to be funded. The performance of the
project is monitored by financial markets and financial institutions. In this way fiscal system controls
the performance of borrowers.
3. The financial system provides payment mechanism for exchange of goods and services for the purpose
of safe and prompt movement of funds. E.g., banks provide facilities of payment and transfer of funds
through cheques, drafts, credit cards etc.
4. It provides protection against risk involved in mobilising savings and allocating credit. E.g., stock
exchanges prescribe rules of operations so that risk is reduced. Derivatives, i.e. futures, forward,
options trading are risk shifting devices. For the purpose of minimising risk, the intermediaries resort to
holding diversified portfolios.
5. Financial system provides information necessary to savers, borrowers arid intermediaries who have to
take important financial decisions. Such price-related and other financial data provided by financial
system help them in their decisions about investing, disinvesting, or reinvesting.
6. The system helps in lowering transaction costs, thus increasing returns to the savers. It also reduces
cost of borrowing funds, so that borrowers are encouraged to expand their business leading to
economic growth. At the same time due to lower cost the savers are motivated to save more.
7. Portfolio adjustment is facilitated by financial system. This facility is provided by financial
intermediaries like banks, mutual funds etc.

As Prof. Jeff Madura wrote, "If financial markets were perfect, all information about any securities for
sale in primary and secondary markets, including the credit worthiness of the security issuer, would be
continuously and freely available to investors. Furthermore all securities for sale could be broken
down into any size desired by investors, and security transaction costs would be non-existent. Under
these conditions financial intermediaries would not be necessary.

Because markets are imperfect, security buyers and sellers do not have full access to information and
cannot always break down securities to the precise size they desire. Financial institutions are
needed to resolve the problems caused by market imperfections. They receive requests from
surplus and deficit units on what securities are to be purchased or sold and they use this
information to match up buyers and sellers of securities."

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M.B.A (FINANCE) , I.C.W.A (INTER)
 P R A V I N M A N D O R A G R O U P T U T I O N S
FINANCIAL SYSTEM

THE STRUCTURE OF THE FINANCIAL SYSTEM : The financial system of any country consists of
specialised & non-specialised financial institutions, of organised & unorganized financial markets,
of financial instruments & services which facilitate transfer of funds.
The Indian financial system is broadly classified into 2 broad groups : (i) Formal or
Organised sector (ii) Informal or Unorganised sector.
FINANCIAL SYSTEM

Financial Financial
Financial Financial Instruments Services
Institutions Markets (Claims, Assets,
Securities)

Banking Non-banking Primary Secondary

Organised Unorganised

Short Medium Long

Term Term Term
Primary Secondary

Capital Markets Money Markets

1. Organised sector : The organized sector comprises of an impressive network of banks, financial &
investment institutions & a range of financial instruments. It comes under the control of Ministry of
finance (MOS), RBI, SEBI & other regulatory bodies.
2. Unorganised sector : This sector consists of individual moneylenders, chit-fund companies,
associations etc. They function under a system of their own rules.

The basic emergence of this unorganised sector is minimum rules, minimum requirements of
documents, easy finance availability, custom made solutions. Organised sector follows the strict
rules set by RBI & other institutions. So those who does not get loan will approach to unorganised
sector as they are less strict. But the rate of interest is high in unorganised sector.
COMPONENTS OF FINANCIAL SYSTEM

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FINANCIAL SYSTEM

Financial system, well-developed and efficiently working are essential for economic growth of the
country. It is widely recognised that an economy cannot expect to have a long-term stable
development, unless it is supported by a well-developed, healthy and vibrant financial system.
There are four components of a financial system, namely, (1) Financial Markets (2) Financial
Institutions (3) Financial Instruments (4) Financial Services.

1. Financial Markets : The main function of financial market is to facilitate transfer of funds from
surplus sectors i.e. lenders or investors to needy sectors i.e. borrowers. Thus, financial markets
perform a crucial function, of linking savers or investors and borrowers.

There are two types of financial markets, namely organised sector and unorganised sector.
Organised markets are those which are properly constituted by legal procedure and are controlled
by regulating authority. The unorganised or informal financial markets are those which are not
under the control of any regulatory body. E.g., individual money lenders or chit funds or funds or
associations which frame their own rules of working.

Financial markets can also be refered as those centres and arrangements which facilitate buying
and selling of financial assets, claims and services.

The functions of financial markets : (1) It facilitates savings to be diverted to investment. (2) It assists
the process of balanced economic growth. (3) It provides efficient payment mechanism.
(4) It provides facilities for buying and selling of shares and other securities and thus provides
financial convenience. (5) It serves as intermediaries for mobilisation of savings.

There are mainly two types of financial markets : (1) Money market and (2) Capital market.

1) Money Market: Money market is that market where borrowers and lenders exchange short term
funds, generally for less than one year. The broad objectives of the money market are to provide:
(1) An equilibrating mechanism for evening out short term surpluses and deficiencies. (2) A focal
point of Reserve Bank intervention for influencing liquidity in the economy. (3) A reasonable
access to the users of short term funds to meet their requirement at reasonable price cost.
The financial instruments used in money market are commercial papers, Treasury Bills,
Certificates of deposit etc.

2) Capital Market : It is a market for long-term funds raised in the form of shares, debentures, bonds
etc. The main institutions of capital market are Stock exchanges, mutual funds, foreign
institutional investors. They facilitate the investment of funds for long period of time.

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M.B.A (FINANCE) , I.C.W.A (INTER)
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FINANCIAL SYSTEM

The long-term funds are raised by companies by issuing shares or debentures. They have to decide
as to what type of shares are to be issued, at what time, at what price etc. These are the new issues
and market in which such issues are made is called primary market. Once shares are issued they are
bought and sold on stock exchanges, which are secondary markets. The investors who buy new or
existing shares are called shareholders or members of the company.
Thus there are two segments of capital market (1) Primary market (2) Secondary market. The
primary market deals with new security issues and the main players of primary market are the
individual investors, foreign institutional investors, merchant bankers, mutual funds, financial
institutions, stock brokers etc. The secondary market is a market where securities already issued are
bought and sold. The major players of secondary markets are stock brokers who are members of
stock exchanges, foreign institutional investors, mutual funds and individual investors.

There are two components of the secondary market: Over the Counter (OTC) market and the
Exchange traded market. The government securities market is an OTC market. In an OTC market,
spot trades are negotiated and traded for immediate delivery and payment while in the Exchange
traded market, trading takes place over a trading cycle in stock exchanges. Recently, the derivates
marketexchange traded has come into existence.

2. Financial Institutions : Financial institutions are intermediaries that mobilize savings and facilitate
the allocation of funds in an efficient manner. They pool funds from savers and provide them to
corporate sector and others who need finance.

There are different types of financial institutions. The main institution is the commercial bank which
collects money in the form of various types of deposits and lend them to industry and trade. But
banks lend money for a short period of time. So, financial institutions like IFCI, IDBI, ICICI have
been established in the post-independent period. They provide funds for 10-20 years to industries.
Besides, there are specialised financial institutions like NABARD, HUDCO, Export-Import Bank
which provide finance to particular segment of the economy. There are mutual funds which work as
links between savers and borrowers like Unit Trust of India and other mutual funds in private
sector and public sector.

There are state-level financial institutions such as the State Financial Corporations (SFCs) and State
Industrial Development Corporations (SIDCs) which are owned and managed by the State
governments.
In the post-reforms era, their role and nature of activity have undergone tremendous change. Banks
have now undertaken non-bank activities and financial institutions are planning to undertake
banking functions. Most of the financial institutions now resort to financial markets for raising
funds.

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FINANCIAL SYSTEM

3. Financial Instruments : Financial instruments like share, debentures, treasury bills, commercial
papers are the main instruments of linking savings and borrowing. They represent a claim against
the future income and wealth of others. It is a claim against a person or institutions for the payment
of the some of the money at a specified future date. There are two types of financial instruments,
namely, (i) money market instruments of short duration of less than one year e.g. treasury bills,
commercial papers, certificates of deposit etc. and (ii) capital market securities like shares,
debentures, bonds etc of a long duration.

Financial instruments or securities are also classified as primary or secondary securities. Primary
securities are also termed as direct securities as they are directly issued by the ultimate borrowers of
funds to the ultimate savers. E.g., primary or direct securities include equity shares and debentures.
Secondary securities are also referred to as indirect securities, as they are issued by the financial
intermediaries to the ultimate savers. E.g., Bank deposits, mutual fund units, and insurance policies
are secondary securities.

Financial instruments differ in terms of marketability, liquidity, reversibility, type of options, return,
risk and transaction costs. Financial instruments help the financial markets and the financial
intermediaries to perform the important role of channelizing funds from lenders to borrowers.

4. Financial Services: Financial Services are provided by financial intermediaries. Financial services can
be defined as "activities, benefits and satisfaction connected with sale of money that offers to users
and customers, financial related values, e.g. banks, insurance companies, stock brokers, mutual
funds stock exchanges, merchant bankers, credit-rating agencies depositories etc. Financial services
rendered by the financial intermediaries bridge the gap between lack of knowledge on the part of
investors and increasing sophistication of financial instruments and markets. These financial
services are vital for creation of firms, industrial expansion, and economic growth.

Before investors lend money, they need to be reassured that it is safe to exchange securities for
funds. This reassurance is provided by the financial regulator who regulates the conduct of the
market, and intermediaries to protect the investors' interests. The Reserve Bank of India regulates
the money market and Securities and Exchange Board of India (SEBI) regulates capital market.

FINANCIAL ASSETS/INSTRUMENTS :

Financial assets/instruments/securities represent claims on a stream of income and/or assets of

another economic unit & are held as a store of value & for the return that is expected.

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FINANCIAL SYSTEM

They are divided into 3 broad categories :

1. Primary/Direct securities : They are classified as :

Ordinary or Equity shares : They are ownership securities & represent risk capital. The owners of
such securities are the real owners of the company. They bear the risk & so they have right on
residual income & assets of the company. They have voting rights. They participate in management
of company.
Debentures/bonds : A debenture is a creditorship security. They receive regular interest on their
investment. They are entitled to receive first claim on the assets of the company. Debentures can be
of irredeemable or redeemable. They can be non-convertible or convertible into equity shares.
Preference shares : It is a hybrid security & has features of equity shares & debentures. They are
compulsorily redeemable in 10 years. They receive regular dividend on shares like debentures &
have voting rights like equity shares. They can be convertible or non-convertible, cumulative or non-
cumulative.

2. Indirect securities : They are issued by financial intermediaries like LIC, GIC, BANKS and Mutual
Fund companies. They are better suited to the requirements of the investors, particularly small
investors. Even borrowers also benefit as they get better terms from small investors. These
institutions are expert in their field.

3. Derivative Instruments : As the financial markets are volatile, the price fluctuations in the various
financial assets make it necessary to have some instruments which can reduce the risk. Through the
use of derivatives, one can partially or fully reduce the risks of price fluctuations.

According to Securities Contracts (Regulation) Act, Derivatives include (i) a security derived from
debt instruments/shares/secured or unsecured loan/risk instrument/contract for differences/any
other form of security, (ii) a contract which derives its value from the prices/index of prices of
underlying securities. The most commonly used derivative instruments are forwards, futures &
options.
FORWARD CONTRACTS : A Forward contract is an agreement to buy or sell an asset on a specified
date for a specified price. One of the parties to the contract assume a long position & agrees to buy
the underlying asset on a certain specified future date, for a certain specified price. The other party
assumes a short position & agrees to sell the asset on the same date for the same price.

FUTURES CONTRACT : A Futures contract is a standardized contract between two parties to buy
or sell a specified asset of standardized quantity and quality for a price agreed upon today with
delivery and payment occurring at a specified future date. The contracts are negotiated at a futures
exchange, which acts as an intermediary between the two parties. The party agreeing to buy the
underlying asset in the future, the "buyer" of the contract, is said to be "long", and the party agreeing
to sell the asset in the future, the "seller" of the contract, is said to be " short". The terminology
reflects the expectations of the partiesthe buyer hopes or expects that the asset price is going to
increase, while the seller hopes or expects that it will decrease in near future.

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OPTIONS CONTRACT : An option gives the holder of the option the right to do something. The
holder does not have to necessarily exercise this right.

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M.B.A (FINANCE) , I.C.W.A (INTER)