Chapter 2 THE FINANCIAL SYSTEM

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OUTLINE

Functions of the Financial System Financial Assets Financial Markets Financial Market Returns Financial Intermediaries Regulatory Infrastructure

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THE FINANCIAL SYSTEM

Fund s Deposits/Sha res
Financial Institutions Commercial Banks Insurance Companies Mutual Funds Provident Funds Non-Banking Financial Companies

Fund s Loan s

Suppliers of Funds Individuals Businesses Governments

Demanders of Funds Individuals Businesses Governments

Fund s Securiti es

Financial Markets Money Market Capital Market

Fund s Securiti es

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FUNCTIONS OF THE FINANCIAL SYSTEM

Payment System Pooling of Funds Transfer of Resources Risk Management Price Information for Decentralised

Decision Making

Dealing with Incentive Problem

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FUNCTIONS OF THE FINANCIAL SYSTEM

Payment System Depository financial intermediaries such as banks are the pivot of the payment system. Credit card companies play a supplementary role. Pooling of Funds Financial markets and intermediaries facilitate the pooling of the household savings for financing business. Transfer of Resources The financial system facilitates the efficient lifecycle allocations of household consumption, the efficient allocation of physical capital to its most productive use, and the efficient separation of ownership from management.

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FUNCTIONS OF THE FINANCIAL SYSTEM

Risk Management A well-developed financial system offers a variety of instruments that enable economic agents to pool, price, and exchange risk The three basic methods of managing risk are : hedging, diversification, and insurance Price Information for Decentralised Decision Making Interest rates and security prices are used by households in their consumption-savinginvestment decisions and by firms in their investment and financing decisions

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FUNCTIONS OF THE FINANCIAL SYSTEM

Dealing with Incentive Problems Information asymmetry leads to moral hazard and adverse selection, which are broadly referred to as agency problems. Financial problem intermediaries of informational like banks and by

venture capital organizations can solve the asymmetry handling sensitive information discreetly and
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FINANCIAL SECTOR REFORMS IN INDIA The financial sector reforms initiated from the early 1990s have focused on the following objectives:

Removal of financial repression.

Creation of an efficient, productive, and profitable financial sector.

Evolution of market-determined interest rates.

Granting of operational and functional autonomy to institutions. Opening of operational and functional autonomy to institutions.

Opening up of the external sector in a calibrated fashion.

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FINANCIAL ASSETS

Financial

assets

are

intangible

assets

that represent claims to future cash flows. The terms financial asset, instrument, or security are used interchangeably

Examples : A 10-year bond issued by the GOI

carrying an interest Centre for rate of 7 percent. Financial Management ,

FINANCIAL MARKETS

A financial

market

is

market

for

creation and exchange of financial assets.

Financial markets play a very pivotal role in allocating they :

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resources in the economy by

performing three important functions as

FUNCTIONS OF FINANCIAL MARKETS

Facilitate Price Discovery The continual interaction among numerous buyers and sellers who participate in financial markets helps in establishing the prices of financial assets Provide Liquidity Thanks to the liquidity provided by financial markets, it is possible for companies (and other entitities) to raise long-term funds from investors with short-term horizons Reduce the Costs of Transacting Financial markets considerably reduce the following costs of transacting Search cost Information cost
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CLASSIFICATION OF FINANCIAL MARKETS

DEBT MARKET NATURE OF CLAIM EQUITY MARKET MONEY MARKET MATURITY OF CLAIM CAPITAL MARKET PRIMARY MARKET SEASONING OF CLAIM SECONDARY MARKET CASH OR SPOT MARKET TIMING OF DELIVERY FORWARD OR FUTURES MARKET EXCHANGE-TRADED MARKET ORGANISATIONAL STRUCTURE OVER-THE-COUNTER MARKET

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FINANCIAL MARKET RETURNS Interest Rate Function of the unit of account, maturity, and default risk

Rate of Return on Risky Assets Cash dividend Ending price Beginning price r= + Beginning Beginning price price Capital yield Dividend yield Inflation and RealFinancial Management , Centre for Interest Rate

DETERMINANTS OF RATES OF RETURN

Expected Productivity of Capital Degree of Uncertainty about the

Productivity of Capital

Time Preferences of People Degree of Risk Aversion

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EQUILIBRIUM IN FINANCIAL MARKETS

(a) Supply and demand for loanable funds and determination of interest rate Interest rate ie i e Sf (lending)

Sf

Df (borrowi ng) 0 A B Amount of loanable funds

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(b) Supply and demand for securities and determination of prices Pric e P e P e

SS (borrowing)

Ds Ds (lending) 0 A Amount of securities B

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FINANCIAL INTERMEDIARIES
Reserve Bank of India Commerci al banks
Development al financial institutions

Insurance companies

Other public sector financial institutions

Mutual funds

Non-banking financial corporations

Public sector banks

All India institutions

Life Insurance Corporation of India Private sector insurance companies

POSB

Unit Trust of India

Publi c secto r firms

NABARD

Private sector banks

State level institutions

NHB General Insurance Corporation of India

Other mutual funds

Privat e sector firms

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RATIONALE FOR FINANCIAL INTERMEDIARIES

Diversification Lower Transaction Cost Economies of Scale Confidentiality Signalling

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RATIONALE FOR FINANCIAL INTERMEDIARIES

Diversification The pool of funds mobilised by financial intermediaries is invested in a broadly diversified portfolio of assets (loans, stocks, bonds and so on). Lower Transaction Cost The transaction cost in percentage terms decreases as the transaction size increases. Economies of Scale Financial institutions enjoy economies of scale Confidentiality Information shared with financial intermediaries may be kept confidential whereas information disclosed to numerous individual investors is in Centre for Financial Management , public domain.

REGULATARY INFRASTRUCTURE

RESERVE BANK OF INDIA SEBI

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KEY TRENDS IN THE INDIAN FINANCIAL SYSTEM Market-determined interest rates and greater volatility of interest rates Emergence of universal banks Emphasis on prudential regulation and supervision Gradual integration with the global financial system Increase in financial innovation Centre for Financial Management ,

SUMMING UP
The financial system consisting of a variety of institutions, markets, and instruments related in a systematic manner provides the principal means by which savings are transformed into investments.

The financial system provides a payment mechanism,

enables the pooling of funds, facilitates the management of uncertainty, generates information for decentralised decision making, and helps in dealing with informational asymmetry.

Financial assets represent claims against the future

income and wealth of others. Financial liabilities, the counterparts of financial assets, represent promises to pay some portion of prospective income and Centre for Financial Management ,

There are different ways of classifying financial markets. The important bases for classification are: type of financial claims, maturity of claims, new issues versus outstanding issues, timing of delivery, and nature of organisational structure.

The interest rate on any type of loan (or fixed income

security) depends on several factors, the most important being the unit of account, the maturity, and the default risk.

Just as a distinction is made between nominal and real

prices, so too a distinction is made between nominal and real interest rates. The nominal interest rate on a bond is the rate of return in nominal terms whereas the real rate is the nominal rate adjusted for the inflation factor.

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Despite a good deal of deregulation in recent years, interest rates in India continue to be substantially regulated.

Financial intermediaries are firms that provide services

and products that customers may not be able to get more efficiently by themselves in financial markets.

Financial intermediaries seem to offer several

advantages : diversification, lower transaction cost, economies of scale, confidentiality, and signaling benefit.

The major financial intermediaries in India are

commercial banks, developmental financial institutions, insurance companies, mutual funds, non-banking financial companies, and merchant banks.

As a maker and enforcer of laws in a society, the

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