Lexicon PPT1[1]

8/2/2019 Lexicon PPT1[1]

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IntroductionThe Financial System


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The Financial System An Introduction

A financial system plays a vital role in the economic

development of any country. It facilitates the flow of funds

from the savers to those who borrow to invest in any

productive ventures. It mobilizes and usefully allocates the

scarce resources of a country.

A financial system is a complex, well integrated set of

subsystems of financial institutions, financial markets,

financial instruments and financial services which facilitates

the transfer and allocation of funds, efficiently and effectively,and in the best interests of all the stakeholders.


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Formal & Informal Financial Sectors

The formal financial sector is characterized by the presence of an

organized, institutional and regulated system which caters to the financial

needs of the modern spheres of the economy.

The informal financial sector is an un organized, non institutional, and non

regulated system dealing with the traditional and rural spheres of the

economy.

The co existence of the formal and informal sectors is commonly referred

to as FINANCIAL DUALISM.

The informal sector has emerged as a result of the intrinsic dualism of

economic and social structures of developing countries and the financialrepression which prevents certain under privileged sections of the society

from accessing funds from the formal sector.


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Formal & Informal Sectors ( cont )

The informal sector is characterized by flexibility of operations andinterface relationships between the creditor and the debtor.

The advantages of the informal sector are low transaction costs, minimaldefault risk, and the transparency of procedures. Due to these advantages,

a wide range and higher rates of interest prevail in the informal sector.

An interpenetration is found between the formal and informal sectors interms of operations, participants, nature of activities, which in turn haveled to their co existence. A high priority should be accorded to the

development of an efficient formal financial sector as it can offer lowerintermediation costs and provide services to a wide base of savers andentrepreneurs.


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The Indian Financial System The Indian Financial System also can be classified into formal

and informal sectors.

The formal financial sector comes under the purview ofMinistry of Finance, RBI, SEBI, IRDA and such other regulatorybodies.

The informal sector consists of individual money lenders (including neighbors, friends , relatives and traders ) andgroups of persons operating as funds or associations. Thesegroups of persons function under a set of their own rules and

use names such as fixed funds, associations and savings clubs. Partnership firms consisting of local brokers, pawn brokers

and non bank financial intermediaries such as finance,investment companies and chit funds also form a part of theinformal financial sector.


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Components Of Formal The Financial system

The formal financial system consists of four

important segments or components

Financial Institutions

Financial Markets

Financial Instruments

Financial Services


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Financial Institutions

These are intermediaries that mobilize the savings in the

economy and facilitate the allocation of funds in an efficient

manner.

Financial institutions can be classified as Banking and Non

Banking Financial Companies.

Banking Companies are creators and purveyors of credit while

Non Banking Financial Companies are only purveyors of

credit.

While the liabilities of the banks are part of the money supply,

this may not be true of non banking financial companies.


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Financial Institutions ( continued ) In India, the major institutional purveyors of credit are

i) Banks SBI Group, Public and Private sector Banks,

Co op Banks, RRBs,

ii) NBFCs Non Banking Finance Companies ,

iii) DFIs - IFCI, IDBI, SIDBI, NABARD, NHB, TFCI, IIFCL,

EXIM BANK Etc.

Investment institutions such as UTI, LIC, GIC, Public and Private Mutual Funds,Public and Private insurance companies, SFCs,SIDCs,SIICs , etc are allclassified as financial institutions and form a part of the formal financialsystem.

In the post reforms era, the nature and activity of these financial institutionshave undergone substantial change. Banks have now taken up non bank

activities and financial institutions have taken up banking functions.

Most of the financial institutions now access the capital market for raisingfunds.


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Financial Markets

Financial markets are a mechanism that enable theparticipants to deal in the financial assets / claims. Themarkets also provide a forum wherein the demands andrequirements interact and set a price for such claims / assets.

The main organized financial markets in India comprise ofMoney Market, Capital Market, Commodities Market andForex Market.

Financial markets can also be classified as Primary marketsand Secondary Markets. While the primary market deals with

new issues, the secondary market is for trading in existing oroutstanding securities.


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Financial Markets ( continued )

There are two components of the secondary market, namely,Over the Counter Market ( OTC ) and the Exchange TradedMarket.

The government securities market is an OTC market. In theOTC market, spot trades are negotiated and traded forimmediate delivery and payment while in the exchangetraded market, trading takes place over a trading cycle instock exchanges ( like BSE and NSE ).

Recently, derivatives market ( Exchange traded ) has alsocome into existence.


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Financial Instruments

A financial instrument is a claim against a person or an institution for

payment of a sum of money at a future date or a periodic payment in the

form of an annuity, interest or dividend.

Financial instruments could be in paper form or electronic form of

dematerialized securities such as shares, bonds, debentures, notes etc.

Most financial instruments are listed and traded on the stock exchanges.

This distinct feature of the financial instruments has enabled the people to

hold a portfolio of different financial assets which in turn help in reducing

the risk.

Different types of financial instruments are being evolved constantly tosuit the changing risk and return preferences of different classes of

investors.


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Financial Instruments ( continued )

Savings and investments are linked through a wide variety ofcomplex financial instruments known as Securities.

Securities are defined in the Securities Contracts RegulationAct, 1956, and include shares, stocks, bonds, debentures and

other marketable securities. Financial securities are financialinstruments that are negotiable and tradable.

Financial instruments differ in terms of liquidity, marketability,reversibility, type of options, risk, return and transactioncosts. Financial instruments help financial markets and

financial intermediaries to help move the funds from savers tousers.


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Financial Services

Financial services are those that help individuals andorganizations with investing, lending, funding and borrowing,selling securities, making payments, and managing risk

exposures in the financial markets.

The major financial services are intermediation of funds,payment mechanisms, provision of liquidity in the financialsystem, risk management and financial engineering.

Funds intermediating services link the saver and the borrowerwhich in turn leads to capital formation. New channels of

financial intermediation have come into existence as a resultof advances in Information & Communication Technologies.


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Financial Services LIQUIDITY is essential for the smooth functioning of a financial system.

Liquidity of financial claims is enhanced through trading in securities.Liquidity s provided by brokers who act as dealers by assisting both sellers

and buyers and also by market makers who provide 2 way quotes.

Financial services are necessary to manage risks

in an increasingly

complex global economy. They enable risk transfer and protection fromrisk.

Risk transfer helps the financial system participants to move unwantedrisks to others who are willing to take risks, like speculators.

The speculators who take risk also need a platform to transfer risk to other

speculators.


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Financial Services ( continued )

In addition, the market participants need financial insurance toprotect themselves from various risks such as exchange raterisks and interest rate risks.

The producers of these financial services are the financialintermediaries such as Banks, Insurance Companies, Mutual

Funds and Stock Exchanges etc. The financial servicesrendered by the financial intermediaries bridge the gapbetween the knowledge on the part of investors and theincreasing complexity of the financial instruments andmarkets.

Regulatory bodies like RBI, SEBI and IRDA etc protect theinterests of the investors and other market participants.

The securities market is regulated by the Ministry Of CorporateAffairs, Department of Economic affairs, RBI, IRDA, and SEBI.


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Functions Of A Financial System The main function of a financial system is to link the savers and

investors and thereby help the mobilization and allocation ofthe savings in the most efficient and effective manner.

A financial system not only helps in selecting the right projectsto be funded but also inspires the operators to monitor theperformance of the investment. Financial markets and

institutions help to monitor corporate performance and exertcorporate control through the threat of hostile takeovers fromunderperforming firms.

A sound financial system should also provide an efficientpayment and settlement system. An efficient payment andsettlement mechanism is crucial to the smooth functioning ofthe economy.

Banks provide this through checks, promissory notes, bills,credit and debit cards, NEFT & RTGS etc and stock exchanges

through depositories & clearing corporations.


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Functions Of A Financial System ( cont

) One of the most important functions of a financial system is toachieve optimal allocation of risk bearing. It limits , pools andtrades the risks involved in mobilizing the savings and

allocating credit.

An efficient financial system aims at containing the risks within

acceptable limits. It lays down rules for operations of thesystem to reduce the risks.

Risk reduction is achieved by holding diversified portfolios and

proper screening of borrowers.

Market participants gain protection from unexpected losses bybuying financial insurance services. Risk is traded in the

financial markets through financial instruments called

Derivatives. are risk shifting devices which shift risk from

those who have it but dont want it to those who are willing to

accept it.


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Functions Of A Financial System ( cont

)

A financial system also makes available price relatedinformation which helps the market participants to takeeconomic and financial decisions. Such information helps theparticipants to form informed opinion about investment,divestments, reinvestment etc.

A financial system also offers portfolio adjustment facilities.These are provided by financial markets and financialintermediaries. This involves a quick, cheap and reliable wayof buying and selling financial assets.

A financial system helps in the creation of a financial structure

that lowers transaction costs, thus helping investors to raisethe return from their assets. It also reduces the cost ofborrowing, thus encouraging the people to save more.

Lastly, a well functioning financial system also helps in

deepening and broadening of the financial markets.


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Key Elements Of A Sound Financial System

The basic elements of a sound financial system are

1) A strong legal & regulatory environment,

2) Stable Money,

3) Sound Public Finances & Public Debt Management,

4) A strong Central bank,

5) A sound banking system,

6) A well functioning securities market, and7) A sound information and communication system.

The importance of each of these elements is as under -


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Key Elements Of A Financial System

1) Since finance is based on contracts, a strong legal andregulatory environment that strictly enforces laws canalone protect the rights and interests of the investors andother market participants. Hence a strong legal andregulatory environment is a fundamental requirement of asound financial system.

2) Stable money is an important constituent as it serves as amedium of exchange, a store of value ( a reserve of futurepurchasing power )and a standard of value for all the goods

and services we may wish to trade in. Large fluctuationsand depreciation in the value of money lead to financialcrises and impede the growth of the economy.


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3) Sound public finance includes setting and controlling publicexpenditure priorities and raising revenues adequate to fund

them efficiently. Historically, these financing needs of the

governments world over led to the creation of financial

systems. Developed countries have sound public finances and

public debt management practices, which result in the

development of a sound financial system.

4) A central bank supervises and regulates the operations of the

banking system. It acts as a banker to banks and to

government , manages public debt and forex reserves and is

the lender of last resort. The central banks monetary policy

influences the pace of economic growth. Hence an

autonomous central bank is a prerequisite for a sound

financial system.


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5) A good financial system must also have a variety of banks both with domestic and international operations- together

with an ability to withstand adverse shocks without failing.

Banks are the core financial intermediaries in all countries.

They perform diverse key functions such as operating the

clearing & payment systems, and forex markets. The banking

system is the main fulcrum to implement the monetary policy

actions. The financial soundness of the banking system

depends upon how efficiently they perform these functions.

Hence, a healthy banking system is another key prerequisiteof a sound financial system.


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Key Elements Of A Financial System6) Another fundamental element of a sound financial system is

an efficient information and communication system. All theparticipants in the financial markets require information andneed to communicate. A sound financial system can developonly when proper disclosure practices and networking of

information systems are adopted.7) Securities markets facilitate issue and trading of securities,

both equity and debt. Efficient security markets promoteeconomic growth by mobilizing and deploying funds intoproductive uses, lowering the cost of capital for firms,

enhancing liquidity and attracting foreign investment. Anefficient securities market strengthens market discipline byexerting corporate control through the threat of hostiletakeovers of underperforming firms. Existence of efficientsecurity markets, therefore, is also a key element of a sound

financial system.


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Financial System Designs A financial system is a vertical arrangement of a well

integrated chain of financial markets and institutions thatprovide financial intermediation. Different designs of financialsystems are found in different countries. The structure of theeconomy, its evolution, political, technical and culturaldifferences affect the design of the financial system.

Two prominent designs can be identified from amongst thevarious designs that exist.

At one end is the bank dominated system, such as in Germany,where a few large banks play a dominant part and the stock

market is not so important. At the other end is the market dominated system, such as in

the USA where markets play a dominant role and the bankingsystem is not so much concentrated.


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Financial System Designs In the bank based financial systems, banks play a pivotal role in mobilizing

savings, allocating capital, overseeing the investment decisions of

corporate managers, and providing risk management facilities.

In the market based financial systems, securities markets take center stage

with banks in mobilizing the societys savings for firms, exerting corporate

control, and easing risk management.

Most of the other major industrial countries fall in between these two

extremes. Bank based systems tend to be stronger in countries where

governments have a direct hand in industrial development. In India, banks

traditionally have been the dominant entities in financial intermediation.

Nationalization of banks, administered interest rate regimes and the

governments policy of favoring banks led to the predominance of a bank

based financial system.


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Financial System Designs

Strangely, there are bank based systems in some developed countrieswhile there are market based systems even in some underdevelopedcountries as shown hereunder

---------------------------------------------------------------------------------------

Level of development Bank based Market based

------------------------- ------------------- -------------------

Developed Japan, Germany, USA, Singapore

France, Italy Korea, Malaysia

Underdeveloped Argentina, Pakistan, Brazil, Mexico

Sri Lanka, Bangladesh Turkey, Philippines

---------------------------------------------------------------------------------------


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Comparison of Bank Based And

Market Based Financial Systems

Given these two types of financial systems, questions arise about the advantages anddisadvantages of a bank based system vis a vis market based system. Each system has itsown merits and demerits.

Proponents of market based system argue that

1) Efficiency is associated with the functioning of competitive markets.

2) Financial markets are attractive as they provide the best terms to both investors andborrowers.

3) Stock markets facilitate diversification and allow efficient risk sharing.

4) They provide incentive to gather information that is reflected in stock prices and these

prices, in turn, provide signals for an efficient allocation of investment.5) One important area in which financial markets perform differently from financialintermediaries is when a diversity of opinion exists such as the financing of newtechnologies or when an unusual decision has to be made. Hence, in emerging industrieswith substantial technological risks, a market based system may be preferable.


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Drawbacks Of A Market BasedFinancial System A market based financial system has three drawbacks

1) It is more susceptible to volatility and instability.

2) Its investors are exposed to market risks.

3) There is a Free Rider problem.

The last drawback arises when no individual is willing to

contribute towards the cost of something but hopes thatsomeone else will bear the cost. This problem ariseswherever there is a public good and separation of ownershipfrom control. For example, shareholders take little interest inthe management of the companies, hoping someone else willmonitor the executives. In a market based system, free riderproblem blunts the incentives to gather information.


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Market based Vs Bank based systems On the other hand, a bank based system is perceived to be

more stable, as the relationship with the parties is moreclose. This leads to the formation of tailor-made contracts

and financial products and efficient inter-temporal risk

sharing.

Financial intermediaries can eliminate the risks that can notbe eliminated at a given time , but can be averaged over time

through inter-temporal smoothing of asset returns.

This requires that investors accept lower returns than what

market offers in some periods in order to get higher returnsin other periods. This provides an insurance to the investors

who would otherwise be forced to liquidate their assets at

disadvantageous prices.


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Market based Vs Bank Based Systems The banking system avoids some of the information

deficiencies of the security markets. The free rider problem iseliminated as private incentives to gather information are

higher in the case a bank based system. Moreover, banks can

perform the screening and monitoring functions on behalf of

the investors. These functions, left to themselves, can beundertaken only at a high cost.

The greatest drawback of a bank based system is that it

retards innovation and growth as banks have an inherent

preference for low riskreturn projects. Moreover, powerfulbanks may collude

with managements against other investors, which, in some

cases could impede competition, effective corporate control

and entry of new firms.


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Current Trends The Current trend all over the world is a preference for the

market based systems. France and Japan have reformed theirmarkets to make them more competitive. It is partly due to

the growing volume of banking activity in the financial

markets.

The European Union is moving towards single unified marketto increase its global competitiveness.

In India also , the role of stock markets has gained

prominence in the post reforms period. The Government has

put in substantial efforts to reform the financial markets. TheIndian equity market is now on par with some of the most

developed markets in the world.

The ratio of market capitalization to the total assets of

scheduled commercial banks has risen sharply from 28.4% in

March 1991 to 79.3% in March 2000.


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Current Trends ( continued )

The relative share of banks in the aggregate financial assets ofbanks and financial institutions taken together which stood at

nearly 75% in early 1980s is now at 55%, implying that there

is considerable potential for growth in market financing.

Research economists have put forward two explanations forthe universal popularity of market based systems

i) Government intervention is regarded as a negative factor and

government failures are as important a problem as market

failures.ii) Economic theory, pertaining to firms, stresses the

effectiveness of free markets in optimum allocation of

resources.


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Which One Is Better?

Empirical analysis in various researches do notsuggest emphatically the superiority of one system

over the other.

Whatever be the type of financial system, both

financial intermediaries and financial markets play acrucial role in the development of a sound financial

system. Both systems can co exist as they encourage

competition, help reduce transaction costs, and

improve resource allocation within the economy

fostering development of a sound financial system

and over all economic growth.


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Nature And Role Of

Financial Institutions & Financial Markets Financial institutions are business organizations serving as link

between savers and borrowers, and so help in the creditallocation process. Sound financial institutions are vital to thesmooth functioning of any economy.

History has shown time and again that countries withdeveloped financial institutions grow faster and countrieswith weak financial institutions face financial crises.

Lenders and borrowers differ in terms of risk, return andterms of maturity. Financial institutions assist in resolving thisconflict between lenders and borrowers by offering claimsagainst themselves and , in turn, acquiring claims againstborrowers.


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Financial Institutions & Markets ( cont

)

Financial institutions provide 3 transformational services -1) Liability, asset and size transformation consisting of

mobilization of funds and their allocation by providing large

loans on the basis of numerous small deposits.

2) Maturity transformation by offering the savers tailor made

short term claims or liquid deposits and so offering to

borrowers long term loans matching the cash flows generated

by their investments.

3) Risk transformation by transforming and reducing the risk

involved in direct lending by acquiring diversified portfolios.


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Financial Institutions & Markets

(cont) Through these services, financial institutions are able to tap

savings that are otherwise unlikely to be acceptable.Moreover, by facilitating the availability of finance, financialinstitutions enable the consumers to spend in anticipation offuture income and the entrepreneur to acquire physicalcapital.

The role of financial institutions has undergone a tremendouschange since the introduction of financial sector reforms in

1991. Besides providing direct loans, many financialinstitutions have diversified themselves into other areas offinancial services such as Merchant Banking, Underwritingand Issue Of Guarantees.


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Financial Markets Financial markets are an important component of the

financial system, They are a mechanism for the exchange

trading of financial products under a policy framework.

The participants in the financial market are the borrowers(issuers of securities ), lenders ( buyers of securities ) and

financial intermediaries.

Primarily, there are four major components of the financialmarket

1) The Money Market, 2) The Capital Market,

3) The Forex Market, and 4) The Commodities Market


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The Money Market A Money Market is a short term debt market where the

debt instruments have maturity up to one year. It is a highly liquid market wherein securities are bought and

sold in large denominations to reduce transaction costs. Call

Money Market, Certificates of Deposits, Treasury Bills and

Commercial Paper are the major instruments in the Moneymarket.

The important functions of the Money Market are

i) To serve as an equilibrating mechanism to redistribute cash

balance in accordance with the liquidity needs of theparticipants,

ii) To form the basis for the management of liquidity and

money in the economy by monetary authorities, and

iii) to provide reasonable access to the users of short term


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The Capital Market

The Capital Market is a market for long term securities equity and debt . The purpose of the Capital Market is to

1) Mobilize long term savings to finance long term investments,

2) Provide risk capital in the form of equity or quasi-equity toentrepreneurs,

3) Encourage broader ownership of productive assets,

4) Provide liquidity with a mechanism enabling the investor tosell financial assets,

5) Lower the costs of transactions and information, and

6) Improve the efficiency of capital allocation through acompetitive pricing mechanism.


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Money Market & Capital Market There is a strong link between the Money market and the

Capital Market as under

1) Often, financial institutions actively involved in the CapitalMarket are also involved in the Money Market.

2) Funds raised in the money market are used to provide

liquidity for long term investment and redemption of fundsraised in the capital market.

3) In the development process of financial markets, thedevelopment of money market typically precedes thedevelopment of the capital market.

4) Capital Market is further classified into primary Market andSecondary Market. Primary Market is for new issues whileSecondary Market is for trading in existing outstandingsecurities. A vibrant secondary market is essential to drive the

primary markets.


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Primary Market & Secondary Market Even though secondary market is many times larger than the

primary market, they are interdependent on each other inmany ways

1) The primary market is meant for new issues (IPOs). But thevolume, pricing and timing of new issues is influenced by the

returns in the secondary market.2) Returns in the stock market depend on macroeconomic

factors. Favorable macroeconomic factors help the firms earnhigher returns which in turn create favorable conditions forthe secondary market. This, in turn, affects the market prices

of stocks.3) Moreover, favorable macroeconomic factors also necessitate

fresh capital raising to finance new projects as also expansionand modernization of existing projects. A buoyant secondarymarket , in turn, promotes the primary market.


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Primary & Secondary Markets ( continued )

3) The secondary market also provides a basis for the

determination of prices at which new issues can be offered in

the primary market.

4) The depth of the secondary market depends upon the

activities in the primary market, because, bigger the entry ofcorporate entities in the primary market, larger is the number

of instruments available for trading in the secondary market.

5) New issues of a large size and bunching of issues may divert

funds from the secondary market to the primary market,thereby temporarily depressing stock prices.


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Characteristics Of Financial Markets

1) Financial Markets are characterized by a large volume oftransactions and the speed with which financial resourcesmove from one market to another.

2) There are various segments of financial markets such as Stockmarkets, bond markets, primary and secondary markets,

where savers themselves decide when and where they shouldinvest money.

3) There is scope for instant arbitrage among various marketsand types of instruments.

4) Financial markets are highly volatile and susceptible to panicand distress selling as the behavior of a limited group ofoperators can get generalized.


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Characteristics Of Financial Markets ( cont

)

5) Markets are dominated by financial intermediaries who takeinvestment decisions as well as risk on behalf of theirdepositors.

6) Negative externalities are associated with financial markets. A

failure in any one segment of the market may affect othersegments, including non financial markets.

7) Domestic financial markets are getting integrated with globalfinancial markets. The failure and vulnerability in a particulardomestic market can have international ramifications in a

globalised world.

In view of the above characteristics, financial markets need tobe closely monitored and supervised.


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Functions Of Financial Markets The cost of acquiring information and making transactions

creates incentives for the emergence of financial markets andinstitutions. Different types and combinations of informationand transaction costs motivate distinct financial contracts,instruments and institutions.

Financial markets perform various functions as under

1) Enabling economic units to exercise their time preference,2) Separation, distribution, diversification and reduction of risk,

3) Operating efficient payment and settlement mechanisms,

4) Providing information about companies. This spurs investors

to make inquiries themselves and keep track of companiesactivities with a view to trading in their stock efficiently, and

5) Transmutation or transformation of financial claims to suit thepreferences of both savers and borrowers.


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THANKYOU

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Lexicon PPT1[1]