FINANCIAL SYSTEM ee 1.1 INTRODUCTION Financial system is a network of financial institutions, financial markel financhal Servic sto facilitate the tre or of funds, Diff rent components of the financial system are interdopendent and operate in cohesiveness to produce a competitive, h icient structure and environment inwhich investors undertake the investment ¢ s of savers, intermediaries, instruments and the ultimate users of funds. The level of economic growth largely depends upon and is facilitated by the state of financial system prevailing in the economy. 4.2 DEFINITION OF FINANCIAL SYSTEM Financial system is combination of two terms ie., finance and system. Finance means monetary comprising ownership funds and debts. Finance is nothing but an exchange of available But itis not limited only to the exchange. A barter trading system is also a typé of finance is, we can Say, Finance is an art of management of various available resources like money, assets, ments, securities, ete. financial instruments and System indicates a set of interrelated parts working together to achieve some purpose. The financial system of an economy exists to organize the settlement of payments, to raise and allocate finance, and to manage the risks associated with financing and exchange. According to Prasanna Chandra, “financial system consists of a variety of institutions, markets and instruments related in a systematic manner and provide the principal means by which savings are transformed into investments’. According to Christy, the objective of the financial system is to “supply funds to various sectors and activities of the economy in ways that promote the fullest possible utilization of resources without the destabilizing consequence of price level changes or unnecessary interference with individual desire”. According to Robinson, the primary function of the system is “to provide a link between savings and investment for the creation of new wealth and to permit portfolio adjustment in the composition of the existing wealth.” From the above definitions, it may be said that the key funetion of the financial system is the mobilisation of savings, their distribution for industrial investment and stimulating capital formation to accelerate the Process of economic growth. Thus, financial system of a country is concerned with -Institutions and Financial Services Financial Markets, i) Allocation and mobilization of savings i) Provision of funds, iii) Facilitating the financial transactions, i) Developing financial markets, V)__ Provision of legal financial framework, and vi) Provision of financial and advisory services. lated and inter-dependent variables ig Broadly speaking, financial system deals with three inter-rel money, credit and finance. The Indian financial system consists of many financial institutions and the mechanism which affects the generation, mobilisation and distribution of savings of the community among all those who demand the funds for investment purposes. Efficient financial system ang sustainable economic growth are corollary. The financial system mobilises the savings and channelises them into the productive activities and, thus, influence the pace of economic development. ‘An economic development of a country directly depends on the pace of increase in saving and investment. When there is an increase in income, part of itis saved and in course of time this savings is used in productive activities. In the accomplishment of this networking, a well-organized financial system is indispensable. The diagrammatic presentation of financial system has been shown below in Figure 1.1: : eR ROT Figure 1.4 The Indian Financial System The Indian Financial System is classified into the formal (organised) financial system and the informal (unorganised) financial system. The formal financial system comes under the purview of the Ministry of Finance, the Reserve Bank of India (RBI), the Securities and Exchange Board of India (SEBI), and other regulatory bodies. The informal financial system consists of: individuals money lenders such as neighbours, relatives, landlords, traders and storeowners. groups of persons operating as ‘funds’ or ‘associations. These groups function under a system of their own rules and use name such as ‘fixed fund’, ‘association’, and 'saving club’. partnership firms consisting of local brokers and non-bank financial intermediaries such as finances, investments and chit fund companies.4.9 FEATU vides @ a) ») °) d) Financial System 5 pes OF FINANCIAL SYSTEM ies relationship between depositors and investors to motivate bath savings and = savings and investments fos expansion of financial marke ittectitat 8 over Space and time it promotes offoctive and efficient allocation of financial resources for socially desirable and renomically productive Purposes. itinfluences both the eminence andl the velocity of economic development 14 FUNCTIONS OF FINANCIAL SYSTEM a) b) ¢) ad e) 9) h) I system, the household savings are channelized to the Mobilisation of Funds: Ina financi which increases the organisations. This leads to increment in production pre business standard of living of peoole, Capital Formation: Financial system mobilizes saving banks and different financial institution, Facilitates Payment: It provides payment mechanism for the exchange of goods and services. and transfer economic resources through time and ¢ Jeographic regions and industries. It offers convenient modes of payment for goods and services. New ways of payments like t cards, debit cards, cheques, etc. facililates quick and easy transactions. Provides Liquidity:The financial market provides the investors the opportunity to liquidate their investments, which are in instruments like shares, debentures, bonds, etc. Price is determined on the daily basis according to the operations of the market force of demand and supply. Short and Long-term Needs: The financial market takes into consideration the various needs of different individuals and organizations, This facilitates optimum utilization of finance for productive purposes. Risk Function: The financial markets provide protection against life, health and income risks. Risk Managementis an essential component of a growing economy. It limits, pools and trades the risk involved in mobilizing savings and allocating credit. Better Decisions: Financial Markets provide information about the market and various financial assets. This helps the investors to compare different investment options and choose the best one. It helps in decision making in choosing portfolio allocations of their wealth. It also makes available price-related information which is valuable assistance to those who need to take economic and financial decisions. It also inspires the operators to monitor the performance of the investors. Finances Government Needs: The financial system supply a huge amount of money to the Government for the development of public health sector, education, social welfare activities and defence infrastructure. It also requires finance for social welfare activities, public health, education, etc. This is supplied to them by financial markets. Economic Development: It helps in the creation of a financial structure that lower: transactions. It has a beneficial influence on the rate of return to savers. It also reduces the cost of borrowings. The Government intervenes in the financial system to influence macro-economic Variables like interest rate or inflation. Thus, credits can be made available to corporates al a cheaper rate. This leads to economic development of the nation for formation of capital through household, 's the cost ofial Services Financial Markets, Institutions and Financ’ in ation of technologies for promoting growth, upgra Sustainable Growth: As it permits continuous UPS} i) ‘on sustainable basis. k) Provides Financial Ser 5: It pn : offers portfolio adjustments facilities. It provides financial services such as insurance, pension ang vices: It provides moting the process of financial ing: It also helps 'n Pre! f financial asset i ing and Broadening increase O cial assets as a 1) Financial oe Financial deepening refers to = broadening refers to building so rentage o ° trumet increasing number anda variety of participants and ins! with Ikdoes this through encouraging Thus, finance helps in production, capital accumulation and Seine uses and users. savings, mobilizing savings and allocation of funds among a 1.5 COMPONENTS OF FINANCIAL SYSTEM nts are inter-relare, There are four basic components of a financial system. All these ou ae sar rene and inter-dependent. These components work and operate in complete quite A een ead one another and provide an efficient financial system. These componen r Private Banks Commercial |. eae Public | Co-operative penke Banks Banking}, L——"*$_} tite Financial Institutions _} [Regional Institutions Rural Banks Non-Banking Institutions Foreign Banks Unorganised Secondary Market Financial Markets Organised & 2 gS a s ey & S s ic Primary Market Financial : Money Assets/Instruments Fund-based |... Financial Services Services Fee-based Merchant Banking, Credit Rating, Stock Services Broking, Custodial Services Figure 1.24.5.1 Financial Market ermancial markets are markets which cater to the financi well as for long period ited. for short as well as for long period. Financial me eps money of individuals, firms and investment barnes ly buy and sell (trade) financial dilows people to eas cial securities (euch as precious metals or agricultural goods), and other ie tere pnd PORES), commodities costs and at prices that reflect the efficient market hypotheses rt eoital, transfer of risk and promoting international trade, The chose eg PS in Hsing of Srganized and unorganized market own private requirement. People use this market as per their Financial Market includes different Sub- Markets: 4) Money market, which provide short-term debt financing and investment. 2) The Capital Market consists of primary market and seconda securities are bought or sold in Primary Markets. Seconda securities that they hold or buy the existing securities, 3) | Commodity market, which facilitates the trading of commodities. 4) Derivatives market, which provide instruments for the management of financial risk. 5) Future market, which provides standardized forward contracts f future date. ry market. Newly formed (Issued) ry markets allow investors to sell for trading products at some 6) _ Insurance market, which facilitates the redistribution of various risks. 7) Foreign exchange market, which facilitates the trading of foreign exchange. 1.5.2 Financial Institution Itis typically an ilstitution that conducts financial transactions such as investments, loans and deposits. Almost everyone deals with financial institutions on a regular basis. Financial institutions or financial Intermediaries act as half-way houses between the primary lenders and the final borrowers. They borrow funds (or accept deposits) from those who are willing to give up their current purchasing power and lend to (or buy securities from) those who require the funds for meeting the current expenditures. Itcan be classified into two categories: 4) Banking Institution: It includes commercial banks, private banks and foreign banks operating in India. There are 27 Commercial Banks of Public Sector. Further, we have Development Banks (ICICI, DBI), Agriculture Bank (RRB, Cooperative Banks, NABARD). 5) _Non-Banking Institution: These are established to mobilise savings in different a institutions do not offer banking services such as accepting deposit and lending loa s. These ns. ForTANTO RTICE POPC A Marnets, Henn not AB FINANCIAL Into, i money an also many ty Table 1.4 Role y Market Nidary Markel 10 secure Provide secx Maik >1VICRS, Issue of se porate advisory servi cur " Subscribe fo unsubscribed portion of My Maney Mark securities {0 the investors on bohyp ere : 7 company and handle share transfer activ, | S \ Money Market Market making in government s | esters | Money Marke Ensure exchange in currencies ‘Slum for creating funds which are u: exchange, bonds, etc sed for borrowing They have high degree of jig ity ty “al Instruments can be categorized into two types Direct Instruments - They 20 the financial claims against real-s¢ m OF raising funds to finance Wwers. The examples are actor Units Creat Towers fi their deficit spending, 1} bills, bonds, equities, book debts etc are financial clain fom the public, OF Indire ct Instruments - They Ms issued by finan, Assets are the ANCE policie: These © bank deposits, lite ing Icial institutions Obligations of the S, Units Of Unit Trust ‘ope ial services, © not covered under financi nto two groups — Ng, Hire Purch hase, Ven urities, De ling in Money ture Capital Consumer Market, ay ealing in Forex surance, and Mutual Funds ete Financing MarketPearl Financial System agement, placement of securities) Jerchant banking (issue manaqe tf secures, d-bavod activities ra nent Consultancy ans Project hivigory Services, Broking Foe nagernont, industrial Inv aor il Discounting, Factoring, Cepositon, 1 Sarvicas, Risk Management, Bil Discounting ‘ veotmnent S01 fan eervices, Credit rating ote, Non-Fund 2) psttlio Mi “ibent am Gunton $s CONOMIC. UTION OF FINANCIAL SYSTEM IN ECONO; 5p CONTRIB OF ACOUNTRY 1.6 COM OPMENT DEVE! ioning of fir nomniG gre, the functioning of iorcauntieapay ameforlelnectievge ee yatta countries play a major #8 Corner ston e tun oarsmen and prxlution le o ¢ tens nt veto and produc experience qrch int Shy when this grows, y whom Sin developing adh ways, A well ‘anil ays arnyr 2 Of an economy. Tr pmnent goal CANOTG grout UA ina country form of ienprovers starwars a4 ng Ke of finan Min We cence eveheperant ch crane) Only sconomicdevelopment. The role of sy 0000 i rary acrbed as fOlOws canbe Ga Peet ve investment and production, Th needs mot tment: To attain economic development +8 Country hs.Gaan be possible only when there is 4 facility for ‘on vthe form of inves savings are channelized to producti ein fn Hoaia mio chnere | institutions hey induce the public to institutions , since pre, the role of financial ‘ iienig atrsclivelntetael rates. These avings are channelized by lending to various ns which are involved in production and distribution, concerns whic! : Any bus capital namely, fixed capital @ sano ia Peeceyany Talsed through capital market by the Issue of debentures and dacee Publ and other financial institutions invest in them in of miimized is Fined capital is used al is raised the day-to-day running of business. is alee Used for purchase of them into finished products, (ii) Government Securities Market: save by business *iN@SS requires two types of ¢ hrough a8 governments to is ensured by the fi (Development of enable businessmen, industrialists as well int their credit requirements, In this way, the devel inancial system, In the absence of key industries like coal ng Gusties will be hamperoa Itis here that the financisi eeivices playa crucial role BY Providing funds for the, Growth of infrastructure j ‘Sector wil] find it difficult to raise th d fe ‘Ora long ti by the government in India. But now, ation, more private sector industries have come forward to indus '¢ Development Banks, hi i captain Aon PI and the Mercha;(vii) (viii) Development of Trade: T reign trade. The financial ins S a result of all thess Generation of Employment Opportunities . 5 t provides wo the p in vario\ sec! to more employ Balanced Growth: simultaneously. T a way that the available funds will be a balanced growth in the industries, agricult lopment requires growth in all the sectory ine country will be geared up by the authorities in sy. the country ‘sectors in such a way, that the among all the se re and service sectors. tem, Governmen Fiscal Discipline and Control of Economy: With the help of financial sys can create an amiable business atmosphere so that there should be neither too much inflation nor depression in the economy. The industries should be given appropriate protection through the financial system so that their credit requirements will be met even during the difficult period The government also regulates financial system so that speculative and illegal transaction could be avoided, Attracts Foreign Capital: The financial system promotes capital market, which is able to attract funds from domestic and international investors. This leads to expansion in investment and result in economic development of a country. Economic Integration: Financial systems of different countries are capable of promoting economic integration. It means there will be common economic policies, investment, trade commerce, commercial law, employment legislation, old age pension, transport co-ordination etc Political Stability: Developed financial system helps in making political conditions stable in the country. An unstable political environment affects financial system of a country as well as its nomic development. Uniform Interest Rate: The financial system is capable to bring an uniform interest rate throughout the country by which there will be balanced movement of funds between centers which ensure availability of capital for all kinds of industries. Technology Development: With the introduction of computers in the financial system, the trasactions have become easy and increased manifold bringing in changes for the allround development of the country. The World Trade Organization (WTO) promoted improved intemational countries. trade and the financial system in all its membery gels Cities = Indian Financial System arly nineties, the p! capaci Janned economic development in India haq fluenced the course of financial development. In the Post-1999. | system that eme d was in response to the imperatives of 1 and deregulated economic era. This has helpeq e more funds for appropriate investments, Till the ¢ greatly int the financial 1 a liberalized, globalised ‘ to mobiliz the Indian economy al system of a country co and markets. INDIAN FINANCIAL SYSTEM nsists of financial institutions, instru. The finan ments, services [ U { I U J FINANCIAL FINANCIAL FINANCIAL FINANCIAL INSTITUTIONS MARKETS INSTRUMENTS SERVICES Merchant Banking Regulatory Organised Primary ¢ Intermediary Unorganised Secondary @ Mutual funds ¢@ Non Intermediary @ Primary Market Short Term Venture capital @ Leasing @ Credit Rating @ Secondary Market # Medium Term Others @ Long Term Depository The evaluation of Indian Financial System can be divided into following three phases: ¢ The financial system up to 1951 (Phase I) ¢ The financial system from 1951 to mid-Eighties (Phase II) ¢ The financial System from 1990 onwards (Phase III)1. The financial system up to 1951 (Phase I) ian financial syst 1 3 ‘fore « syst mC S) before 1951 was largely closed-circle charac mol industrial entrepreneurship; wherein a semi-orpanized and nar tetastrial securities mat ket was devoid of issuing ins sebehes sUitutions. There we surities m ; as : virtual absence of participation by financial intermediaries term financing of industry. Such a system was not ae oe tunities for industrial investment, During this period the industrial sector was neglected by the government. The growth of the period showed a slow growth of economic development reflected in low per capita income, wings, national income and purchasing capacity. ‘ 3, The financial system from 1951, mid-Kighties (Phase 1) post-1951 period evolved in response to the imperatives of planned economic development. Planning signified the distribution of credit and finance in conformity with the planned priorities, which, in turn, implied Government but until the 1980s the volume of activity in the capital market was relatively limited. Capital market activity expanded rapidly in the 1980s and the market capitalisation of companies registered in the Bombay Stock Exchange rose from 5% of GDP in 1980 to 13% in 1990. However the market remained primitive and poorly regulated. Companies wishing to access the capital market needed prior permission of the government which also had to approve the Price at which new equity could be raised. While new issues were strictly controlled, there was inadequate regulation of stock market activity and also of various market participants including stock exchanges, brokers, mutual funds etc. The domestic capital market was also closed to portfolio investment from abroad except through a few closed ended mutual funds floated abroad by UTI which were dedicated to Indian investment. Following the recommendations of the Narasimham Committee the process of reform of the capital market was initiated aimed at removing direct government control and replacing it by a regulatory framework based on transparency and disclosure supervised by an independent regulator. The first step was taken in 1992 when the Securities and Exchange Board of India (SEBI), which was originally established as a non-statutory body in 1988, was elevated to a full fledged capital market regulator with statutory powers. The requirement of prior government permission for accessing capital markets and for prior approval of issue pricing was abolished and companies were allowed to access markets and price issues freely, subject only to disclosure norms laid down by SEBI._1 What are the important functions performed by an efficient financial syste in an economy. Does it help in the economic development of a country? 2 Explain therelationship between financial system and economic development 3 Give a brief description of Financial Markets in India. Explain the role of financial intermediaries. 4 Explain the impact of an efficient financial system on the economic develop. ment of the country with the help of examples of the Indian financial system. 5 Explain the recent reforms in the Indian financial System. 6 What a you mean by financial system? Explain structure of the financial ystem? 1 Give brief deces..c: : : Give brief description of financial markets and financial institutions in India. ;