Components of Financial System:

A financial system refers to a system which enables the transfer of money between
investors and borrowers. A financial system could be defined at an international, regional or
organization level. The term “system” in “Financial System” indicates a group of complex
and closely linked institutions, agents, procedures, markets, transactions, claims and
liabilities within a economy.

A financial system of a country is an tool for economic development of the

country.(https://bbamantra.com/indian-financial-system-introduction/ )
Five Basic Components of Financial System
 Financial Institutions
 Financial Markets
 Financial Instruments (Assets or Securities)
 Financial Services
 Money

Financial Institutions
Financial institutions facilitate smooth working of the financial system by making investors
and borrowers meet. They mobilize the savings of investors either directly or indirectly via
financial markets, by making use of different financial instruments as well as in the process
using the services of numerous financial services providers.

Financial Markets

A financial market is the place where financial assets are created or transferred. It can be broadly
categorized into money markets and capital markets. Money market handles short-term financial
assets (less than a year) whereas capital markets take care of those financial assets that have
maturity period of more than a year.

The key functions are:

1. Assist in creation and allocation of credit and liquidity.
2. Serve as intermediaries for mobilization of savings.
3. Help achieve balanced economic growth.
4. Offer financial convenience.
One more classification is possible: primary markets and secondary markets. Primary markets
handle new issue of securities in contrast secondary markets take care of securities that are
presently available in the stock market.

I. Money Market: The money market is a wholesale debt market for low-risk, highly-liquid,
short-term instrument. Funds are available in this market for periods ranging from a single day
up to a year. This market is dominated mostly by government, banks and financial institutions.

II. Capital Market: The capital market is designed to finance the long-term investments. The
transactions taking place in this market will be for periods over a year.

III. Foreign Exchange Market: The Foreign Exchange market deals with the multi currency
requirements which are met by the exchange of currencies. Depending on the exchange rate that
is applicable, the transfer of funds takes place in this market. This is one of the most developed
and integrated markets across the globe.

IV. Credit Market- Credit market is a place where banks, Financial Institutions (FIs) and Non
Bank Financial Institutions (NBFCs) purvey short, medium and long-term loans to corporate and
individuals.

Financial Instruments
This is an important component of financial system. The products which are traded in a financial
market are financial assets, securities or other type of financial instruments. There is a wide
range of securities in the markets since the needs of investors and credit seekers are different.
They indicate a claim on the settlement of principal down the road or payment of a regular
amount by means of interest or dividend. Equity shares, debentures, bonds, etc are some
examples.

Financial Services
Financial services consist of services provided by Asset Management and Liability Management
Companies. They help to get the necessary funds and also make sure that they are efficiently
deployed. They assist to determine the financing combination and extend their professional
services upto the stage of servicing of lenders. They help with borrowing, selling and purchasing
securities, lending and investing, making and allowing payments and settlements and taking care
of risk exposures in financial markets. These range from the leasing companies, mutual fund
houses, merchant bankers, portfolio managers, bill discounting and acceptance houses.

Money
Money is understood to be anything that is accepted for payment of products and services or for
the repayment of debt. It is a medium of exchange and acts as a store of value.

Capital market:

Capital Markets are markets where financial securities like shares and bonds are issued to raise
medium to long term financing and also where the securities are traded. It helps channelize
surplus funds from small investors to institutions so that it can be put to productive use. It
consists of primary and secondary market. Primary market deals with the issue of new securities
like stocks or bonds. While secondary market deals with the exchange of existing securities.
Another classification of capital market can be done on the basis of nature of securities traded
like bond market or stock market. In short, the securities are issued in a primary market and then
traded in secondary market.

Broadly, capital markets refer to markets of any financial asset. A capital market is where buyers
and sellers trade financial securities such as stocks, bonds, etc. Buyers and sellers can be
individuals or institutions.

Sellers - include life insurance companies, pension funds, and charitable foundations like
religious institutions, hospitals, colleges and non-financial institutions that generate excess cash
beyond their investment needs.

Buyers - include nonfinancial companies, motor vehicle and home purchasers, and governments
financing infrastructure investment and operating expenses.

Capital markets trade mainly in long-term securities and facilitates channelization of surplus
funds from savers to institutions that invest them into productive use. They represent the inherent
strength of the economy and encourage capital creation in the economy by offering a range of
investment avenues to its investors.

Capital market segments

Marketing segmentation is the research that determines how your organization divides its customers or
cohort into smaller groups based on characteristics such as, age, income, personality traits or behavior.
These segments can later be used to optimize products and advertising to different customers.

Market segmentation is a marketing term that refers to aggregating prospective buyers into groups or
segments with common needs and who responds similarly to a marketing action. Market segmentation
enables companies to target different categories of consumers who perceive the full value of certain
products and services differently from one another.
 Segmentation refers to a process of bifurcating or dividing a large unit into various small units which have
more or less similar or related characteristics.

Types of market segmentation:

 Geographic segmentation
 Demographic segmentation
 Psycho graphic segmentation
 Behavioral segmentation

The main functions of capital markets are as follows –

 Mobilization of savings for long term investment financing.

 Help Trading of securities.
 Encourage a broad range of ownership of productive assets.
 Minimization of information and transaction cost.
 Quick valuation of financial instruments including debentures and shares.
 Help in transaction settlement based on the definite time schedules.
 Offer insurance against price or market risk through derivative trading.
 Enhancement in capital allocation effectiveness with the competitive price mechanism.

Types of Capital Market

The capital market is bifurcated in two segments, primary market and secondary market:

1. Primary Market: Otherwise called as New Issues Market, it is the market for the trading of new
securities, for the first time. It embraces both initial public offering and further public offering. In
the primary market, the mobilization of funds takes place through prospectus, right issue and
private placement of securities.
2. Secondary Market: Secondary Market can be described as the market for old securities, in the
sense that securities which are previously issued in the primary market are traded here. The
trading takes place between investors that follows the original issue in the primary market. It
covers both stock exchange and over-the-counter market.

Capital market improves the quality of information available to the investor regarding the
investment. Add to that, it plays a crucial role in encouraging the adoption of rules of corporate
governance, which backs the trading environment. It includes all the processes that help in the
transfer of already existing securities.

Functions of capital markets:

1. Capital arrangement: The capital market promotes capital formation in the country. Rate of
capital formation depends upon savings in the country. Though the banks mobilize savings, they
are not adequate to match the requirements of the industrial sector. The capital market mobilizes
savings of households and of the industrial concern. Such savings are then invested for
productive purposes. Thus savings and investment leads to capital arrangement in country.

2. Economic growth: Capital market smoothes the progress of the growth of the industrial
sector as well as other sectors of the economy. The main purpose of the capital market is to
transfer resources from masses to the industrial sector. The capital market makes it possible to
lend funds to various projects, both in the private as well as public sector.

3. Development of backward areas: The capital markets provide funds for the projects in
backward areas. This facilitates the economic development of backward areas.

4. Generates employment: Capital market generates employment in the country: i) Direct

employment in the capital markets such as stock markets, financial institutions etc. ii) Indirect
employment in all sectors of the economy, because of the funds provided for developmental
projects.

5. Long term capital to industrial sector: The capital market provides a stable long-term
capital for the companies. Once, the funds are collected through issues, the money remains with
the company. The company is left free with the funds while investors exchange securities among
themselves.

6. Generation of foreign capital: The capital market makes possible to generate foreign capital.
Indian firms are able to generate capital from overseas markets by way of bonds and other
securities. Such foreign exchange funds are vital for the economic development of the nation.

7. Developing role of financial institutions: The various agencies of capital market such as
industrial financial corporation of India (IFCI), state finance corporations (SFC), industrial
development bank of India (IDBI), industrial credit and investment corporation of India (ICICI),
unit trust of India (UTI), life insurance corporation of India (LIC), etc. there have been rendering
useful services to the growth of industries. They have been financing, promoting and
underwriting the functions of the capital market.
8. Investment opportunities: Capital markets provide excellent investment opportunities to the
members of the public. The public can have alternative source of investment i.e. In bonds, shares
and debentures etc.

The capital market play very important role in Indian financial system as follow:

1. To mobilize long-term savings to finance long term investments.

2. to inspirations broader ownership of productive assets.

3. To improve the efficiency of capital allocation through a competitive pricing mechanism.

4. To provide liquidity with mechanism enabling the investor to see financial assets.

5. To make lower the costs of transactions and information.

6. To make bridge between investors and companies.

7. To make quick valuation of financial instruments both equity and debt.

8. to security against market risk or price risk trough derivative trading and default risk through
investment protection fund.

9. To provide operational efficiency.

10. To direct the flow of funds into efficient channels through investment, disinvestment, and
reinvestment.

11. To make integration between financial sectors and non-financial sectors, Long term fund and
short term fund.

12. To give opportunities to risk taker in term of equity and return taker in term of debt

Participants of capital market:

Role of Participants in Capital Markets
  Regulators, financial institutions, accountants/auditors, government
 Issuers of securities in capital markets
 Investors in capital markets: individuals and institutional players
 Professionals: brokers, dealers, underwriters
 Financial intermediaries: commercial banks, merchant banks, mutual funds, hedge funds,
insurance companies, pension funds
 Initial public offerings (IPOs)

Who are the participants in the capital market?

Capital market participants:

The supply in this market comes from savings from different sectors of the economy. These
savings accrue from the following sources:

 Individuals.
 Corporate.
 Governments.
 Foreign countries.
 Banks.
 Provident Funds.
 Financial Institutions.

1. Banks:
Banks participate in the capital market and money market. Within the capital market, banks take
active part in bond markets. Banks may invest in equity and mutual funds as a part of their fund
management. Banks take active trading interest in the bond market and have certain exposures to
the equity market also. Banks also participate in the market as clearing houses.

2. Primary Dealers (PDs):

PDs deal in government securities both in primary and secondary markets. Their basic
responsibility is to provide two-way quotes and act as market makers for government securities
and strengthen the government securities market.
3. Financial Institutions (FIs):
FIs provide/lend long term funds for industry and agriculture. FIs raise their resources through
long-term bonds from financial system and borrowings from international financial institutions
like International Finance Corporation (IFC), Asian Development Bank (ADB) International
Development Association (IDA), International Bank for Reconstruction and Development
(IBRD), etc.

4. Stock Exchanges:
A Stock exchange is duly approved by the Regulators to provide sale and purchase of securities
by “open cry” or “on-line” on behalf of investors through brokers. The stock exchanges provide
clearing house facilities for netting of payments and securities delivery. Such clearing houses
guarantee all payments and deliveries. Securities traded in stock exchanges include equities,
debt, and derivatives.

5. Brokers:
Only brokers approved by Capital Market Regulator can operate on stock exchange. Brokers
perform the job of intermediating between buyers and seller of securities. They help build up
order book, price discovery, and are responsible for a contract being honoured. For their services
brokers earn a fee known as brokerage.

6. Investment Bankers (Merchant Bankers):

These are agencies/organisations regulated and licensed by SEBI, the Capital Markets Regulator.
They arrange raising of funds through equity and debt route and assist companies in completing
various formalities like filing of the prescribed document and other compliances with the
Regulator and Regulators.

7. Foreign Institutional Investors (FIIs):

FIIs are foreign based funds authorized by Capital Market Regulator to invest in countries’
equity and debt market through stock exchanges. They are allowed to repatriate sale proceeds of
their holdings, provided sales have been made through an authorized stock exchange and taxes
have been paid. FIIs enjoy de-facto capital account convertibility.
8. Custodians:
Custodians are organizations which are allowed to hold securities on behalf of customers and
carry out operations on their behalf. They handle both funds and securities of Qualified
Institutional Borrowers (QIBs) including FIIs.

Custodians are supervised by the Capital Market Regulator. In view of their position and as they
handle the payment and settlements, banks are able to play the role of custodians effectively.
Thus most banks perform the role of custodians.

9. Depositories:
Depositories hold securities in demat (electronic) form, maintain accounts of depository
participants who, in turn, maintain accounts of their customers. On instructions of stock
exchange clearing house, supported by documentation, a depository transfers securities from
buyers to sellers’ accounts in electronic form.

The various capital market instruments used by corporate entities for raising resources are
as follows:
1. Preference shares
2. Equity shares
3. Non-voting equity shares
4. Cumulative convertible preference shares
5. Company fixed deposits
6. Warrants
7. Debentures
8. Bonds
9. Mutual fund
10. Derivatives
11. Commodities
12. Currency exchange

Capital market instruments:

Meaning of capital market instruments:
Capital market instruments means saving of investors are linked with investments through a
range of complex financial products generally called capital market instruments including shares,
debentures, bonds, fixed deposits and other marketable securities of a like nature issued by an
incorporated company and body corporate, derivatives units issued by any collective investment
scheme to the investors in such schemes, any certificate or instrument (by whatever name called)
investor by any issuer being a special purpose distinct entity which possesses any debt or
receivable, including mortgage debt, assigned to such acknowledging beneficial interest of such
investor in such debt or receivable, including mortgage debt, as the case may be; government
securities instruments as may be declared by the Central Government to be securities.

The instruments issued in capital markets are listed below:

1. Shares: Share is the share in the share capital of the company. Share is one of the units
into which the capital of company is divided. A person having the shares of the
company is called as shareholder of that company; He is regarded as the part of owner
of the company.
There are 2 types of shares:
 Equity shares
 Preference shares

2. Debentures: Debentures are long term borrowed funds of the company. They have fixed
maturity period as well as fixed interest rate. These are the certificates issued under common seal
of the company.

3. Bonds: Bonds are the long term borrowed funds of the government and also companies. Like
debentures have fixed maturity and fixed interest rate even bonds have. Here interest charged on
bonds termed as coupon rate.

4. Derivatives: These are instruments that derive from other securities, which are referred to as
underlying assets. The price, riskiness and function of the derivative depend on the underlying
assets since whatever affects the underlying asset must affect the derivative.

Some examples of derivatives are:

 Futures
 Options
 Swaps
 Exchange Traded Funds or commodities

Fixed Deposit
Fixed Deposit is that kind of bank account, where the amount of deposit is fixed for a specified
period of time. All Commercial banks are given these opportunities to their customers for
opening a fixed account in their bank. In a Fixed account, the amount of deposit is fixed, which
means we cannot withdraw an unlimited amount from this account; therefore it is also called a
Fixed Deposit.

Foreign exchange market (Forex market)

Forex is one of the biggest investment markets in the world and it is a huge platform for
investors for their investment. There are various forms of currencies included for trading on
international level. The investors invest their money on the value of currencies fluctuation
because of variation in the economic position of countries and entire world economy.

Gold ETF
Gold ETF is one of the most popular funds as it does not get influenced due to stock fluctuations
or inflation. Gold ETF fund is a fiscal instrument which works as a mutual fund and whose
prices are depending upon the market price of gold. When the market price of gold increases,
gold ETF prices also increase.
Government instruments – The government, either central government, state government or local
governments, such as, municipalities, metropolitan authorities, port trusts, development trusts,
state electricity boards, public sector undertakings and other government agencies, viz. IDBI,
SFCs, NABARD, SIDCs, etc