PROFESSOR VIPIN
Indian Financial System
For B.Com Students – Bangalore University
Vipin MKS
1/1/2014
Professor Vipin 2014
Unit 1
Financial System
Meaning
The financial system is possibly the most important institutional and functional vehicle for economic
transformation. Finance is a bridge between the present and the future and whether the
mobilization of savings or their efficient, effective and equitable allocation for investment, it the
access with which the financial system performs its functions that sets the pace for the achievement
of broader national objectives.
Classification of Financial System
The financial system consists of four segments or components. These are: financial institutions,
financial markets, financial services.
1. Financial institutions: Financial institutions are intermediaries that mobilize savings &
facilitate the allocation of funds in an efficient manner.
Financial institutions can be classified as banking & non-banking financial institutions.
Banking institutions are creators of credit while non-banking financial institutions are
purveyors of credit. While the liabilities of banks are part of the money supply, this may not
be true of non-banking financial institutions. In India, non-banking financial institutions,
namely, the developmental financial institutions (DFIs) & non-banking financial companies
(NBFCs) as well as housing finance companies (HFCs) are the major institutional purveyors of
credit. Financial institutions can also be classified as term-finance institutions such as the
industrial development bank of India (IDBI), industrial credit & Investment Corporation of
India (ICICI), industrial financial corporation of India (IFCI), small industries development
bank of India (SIDBI) & industrial investment bank of India (IIBI).
2.
Financial markets: Financial markets are a mechanism enabling participants to deal in
financial claims.
The markets also provide a facility in which their demands & requirements interact to set a
price for such claims. The main organized financial markets in India are the money market &
capital market. The first is a market for short-term securities. Money market is a market for
dealing with financial assets & securities which have a maturity period of upto one year.
While the second is a market for long term securities, that is, securities having a maturity
period of one year or more. The capital market is a market for financial assets which have a
long or indefinite maturity.
a) Money market consists of:
i.
Call money market: Call money market is a market for extremely short
period loans say one day to fourteen days. It is highly liquid.
ii.
Commercial bills market: It is a market for bills of exchange arising out of
genuine trade transactions. In the case of credit sale, the seller may draw a
bill of exchange on the buyer. The buyer accepts such a bill promising to pay
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iii.
at a later date the amount specified in the bill. The seller need not wait until
the due date of the bill. Instead, he can get immediate payment by
discounting the bill.
Treasury bills market: It is a market for treasury bills which have ‘short-term’
maturity. A treasury bill is a promissory note or a finance bill issued by the
government. It is highly liquid because its repayment is guaranteed by the
government.
b) Short-term loan market: It is a market where short- term loans are given to
corporate customers for meeting their working capital requirements. Commercial
banks play a significant role in this market.
c) Capital market consists of: Industrial securities market:It is a market for industrial
securities namely equity shares or ordinary shares, preference shares & debentures
or bonds. It is a market where industrial concerns raise their capital or debt by
issuing appropriate instruments. It can be further subdivided into primary &
secondary market.
d) Government securities market: It is otherwise called gilt-edged securities market. It
is a market where government securities are traded. In India there are many kinds of
govt securities- short-term & long-term. Long-term securities are traded in this
market while short term securities are traded in the money market.
e) Long-term loans market: Development banks & commercial banks play a significant
role in this market by supplying long term loans to corporate customers.
3. Financial Instruments: A financial instrument refers to that document which represents
financial claims on assets. As discussed earlier, financial assets refers to a claim to the
repayment of certain sum of money at the end of specified period together with interest or
dividend. Examples: bills of exchange, promissory notes, treasury bills, government bonds,
deposit receipts, shares debentures etc. Financial instruments can also be called financial
securities. Financial securities can be classified into:
a) Primary securities: These are securities directly issued by the ultimate investors to
the ultimate savers. Examples, shares and debentures issued directly to the public.
b) Secondary securities: These are securities issued by some intermediaries called
financial intermediaries to the ultimate savers. E.g. unit trust of India and Mutual
funds issue securities in the form of units to the public and money pooled is invested
in companies.
4. Financial Services: Financial intermediaries provide key financial services such as merchant
banking, leasing hire purchases, credit-rating, and so on. Financial services rendered by the
financial intermediaries bridge the gap between lack of knowledge on the part of investors
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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 Exchange Board of India (SEBI) regulates
capital market.
Financial Markets – Functions
1. Promotion of liquidity: The major function of financial system is the provision of money and
monetary assets for the production of goods and services. There should not be any shortage
of money for productive ventures. In financial language, the money and monetary assets are
referred to as liquidity. The term liquidity refers to cash or money and other assets which
can be converted into cash readily without loss of value and time.
2. Link between savers and investors: One of the important functions of financial system is to
link the savers and investors and thereby help in mobilizing and allocating the savings
effectively and efficiently. By acting as an efficient medium for allocation of resources, it
permits continuous up gradation of technologies for promoting growth on a sustained basis.
3. Information available: It makes available price- related information which is a valuable
assistance to those who need economic and financial decision.
4. Helps in projects selection: A financial system not only helps in selecting projects to be
funded but also inspires the operators to monitor the performance of the investment. It
provides a payment mechanism for the exchange of goods and services, and transfers
economic resources through time and across geographic regions and industries.
5. Allocation of risk: One of most important function of the financial system is to achieve
optimum allocation of risk bearing. It limits, pools, and trades the risks involved in mobilizing
savings and allocating credit. An effective financial system aims at containing risk within
acceptable limit and reducing cost of gathering and analyzing information to assist operators
in taking decisions carefully.
6. Minimizes situations of Asymmetric information: A financial system minimizes situations
where the information is Asymmetric and likely to affect motivations among operators or
when one party has the information and the other party does not. It provides financial
services such as insurance and pension and offers portfolio adjustments facilities.
7. Reduce cost of transaction and borrowing: A financial system helps in creation of financial
structure that lowers the cost of transactions. This has a beneficial influence on the rate of
return to the savers. It also reduces the cost of borrowings. Thus , the system generates an
impulse among the people to save more.
8. Financial deepening and broadening: A well –functioning financial system helps in promoting
the process of financial deepening and broadening. Financial deepening refers to an increase
of financial assets as a percentage of the gross domestic product. Financial broadening
refers to building an increasing number and a variety of participants and instruments.
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Significance of Primary Market
a) This is the market for new long term equity capital. The primary market is the market where
the securities are sold for the first time. Therefore it is also called the new issue market
(NIM).
b) In a primary issue, the securities are issued by the company directly to investors.
c) The company receives the money and issues new security certificates to the investors.
d) Primary issues are used by companies for the purpose of setting up new business or for
expanding or modernizing the existing business.
e) The primary market performs the crucial function of facilitating capital formation in the
economy.
f) The new issue market does not include certain other sources of new long term external
finance, such as loans from financial institutions. Borrowers in the new issue market may be
raising capital for converting private capital into public capital; this is known as "going
public."
Significance of Secondary Market
a) In the secondary market, securities are sold by and transferred from one investor or
speculator to another. It is therefore important that the secondary market be highly liquid.
b) As a general rule, the greater the number of investors that participate in a given
marketplace, and the greater the centralization of that marketplace, the more liquid the
market.
c) Fundamentally, secondary markets mesh the investor's preference for liquidity (i.e., the
investor's desire not to tie up his or her money for a long period of time, in case the investor
needs it to deal with unforeseen circumstances) with the capital user's preference to be able
to use the capital for an extended period of time.
d) Accurate share price allocates scarce capital more efficiently when new projects are
financed through a new primary market offering, but accuracy may also matter.
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