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COLLEGE

S.T. GONSALO GARCIA

CHAPTER 1.INTRODUCTION OF FINANCIAL SYSTEM:The economic development of any country depends upon the existence of a well organized financial system. It is the financial system which supplies the necessary financial inputs for the production of goods and services which in turn promote the well being and standard of living of the people of a country. Thus, the financial system is a broader term which brings under its fold the financial markets and the financial institutions which support the system. The major assets traded in the financial system are money and monetary assets. The responsibility of the financial system is to mobilize the savings in the form of money and monetary assets and invest them to productive ventures. An efficient functioning of the financial system facilitates the free flow of funds to more productive activities and thus promotes investment. Thus, the financial system provides the intermediation between savers and investors and promotes faster economic development.

OVERVIEW OF INDIAN FINANCIAL SYSTEM

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COLLEGE

S.T. GONSALO GARCIA

Financial institutions in countries like India are classified into banking and non-banking financial intermediaries wherein the commercial banks are considered as general or non-specialized financial institutions and the non-banking financial intermediaries like investment banks, insurance companies, term lending financial institutions and development banks are known as specialized financial institutions. Country like India also has dichotomy in the financial market. This dichotomy can be explained in terms of the existence of organized and unorganized financial markets. While all of the above will constitute the organized sector of the financial market, the unorganized financial market in India consists of traditional bankers like the Gujarati shroffs, Multani or Shikarpuri shroffs, Chettiars and Marwari Kayas. The Gujarati shroffs operate in Bombay, Calcutta and the industrial trading centers of Gujarat. The Marwari shroffs operate in Calcutta, Bombay, Assam and other parts of north-east india. The multani or Shikarpuri shroffs are mainly found in Bombay and madras and the chettiars operate in south India. Amongst these traditional bankers, the gujarati shroffs carry out the largest volume of unorganized banking business in India. Non-banking financial companies like chit funds and nidhis also operate in large numbers in India. The third segment of the unorganized financial market in India consists of the money lenders. These unorganized segments are so called because they are neither registered as companies nor being controlled by the reserve Bank of India.

OVERVIEW OF INDIAN FINANCIAL SYSTEM

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COLLEGE

S.T. GONSALO GARCIA

DEFINITION OF FINANCIAL SYSTEM:According to Dr.Prasanna Chandra, The financial system consists of a variety of financial intermediaries, markets and instruments that are related to each other. It provides the principal means by which savings are transformed into investments. Dr. L.M. Bhole defines financial system as The financial system of any country consists of specialized and non-specialized financial institutions, of organized and unorganized financial markets, of financial instruments and services which facilitate transfer funds. Procedures and practices adopted in the markets and financial interrelationships are also parts of the system.

OVERVIEW OF INDIAN FINANCIAL SYSTEM

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COLLEGE

S.T. GONSALO GARCIA

OVERVIEW OF INDIAN FINANCIAL SYSTEM

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COLLEGE

S.T. GONSALO GARCIA

FUNCTIONS OF FINANCIAL SYSTEM:The financial system performs the following functions that are interrelated and are essential for the development process of a modern economy. An integrated picture of the financial system is depicted in Fig.4.1. Payment system Mobilization and allocation of funds Risk management Price information for decentralized decision making Dealing with incentive problem

1) PAYMENT SYSTEM: The commercial banking system, alternatively known as depository financial intermediaries constitutes the payment system in the financial market. The credit and debit card companies play a supplementary role. With large number of commercial banks having their independent credit card and debit card divisions, the credit and debit card system becomes a part of the banking system. Modern economies and societies with the present scale and volume of transactions cannot be imagined in the absence of a payment system as convenient as the banking system we have now. 2) MOBILIZATION AND ALLOCATION OF FUNDS:

OVERVIEW OF INDIAN FINANCIAL SYSTEM

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COLLEGE

S.T. GONSALO GARCIA

The financial intermediaries both banking and non-banking plays a crucial role in mobilizing funds from the persons and households having surplus and allocating it to the deficit persons and firms. The financial markets also help in efficient allocation of scarce financial resources and individuals and households are provided the opportunity to invest their financial resources in attractive financial avenues of investment. The widening and deepening of the financial markets takes place with the growth of the financial markets and availability of innovative and ingenious financial products that can mobilize the smallest of the savings available in the society. According to Robert Merton, A well developed, smooth-functioning financial system facilitates the efficient life-cycle allocation of household consumption and the efficient allocation of physical capital to the mosot productive use in the business sector. A well developed, smooth-functioning capital market also makes possible the efficient separation of ownership from management of the firm. This in turn makes feasible efficient specialization in production according to the principle of comparative advantage.

3) RISK MANAGEMENT: A developed financial system provides a variety of financial instruments that enable financial intermediaries to mobilize; price and exchange risk. It provides opportunities for risk-pooling and risk sharing for both firms and households.OVERVIEW OF INDIAN FINANCIAL SYSTEM Page 6

COLLEGE

S.T. GONSALO GARCIA

The three basic methods of managing risk are: i. ii. iii. Hedging Diversification Insurance

HEDGING: Hedging would require movement from a risk-loaded asset to a risk-free asset. Ex. A forward contract is a hedging device. DIVERSIFICATION: Diversification helps in redistribution of risks in such a manner that the risk faced by every individual is diminished. It does not eliminate risk entirely. Ex. Mutual fund companies offer income, balanced and growth funds. INSURANCE: While income funds are risk free, the risk is balanced in balanced funds and growth funds carry highest level of risk. The risk-return relationship is direct and proportional. Insurance enables the insured to enjoy the economic benefits of ownership while eliminating the possible losses. 4) PRICE INFORMATION FOR DECENTRALIZED DECISION

MAKING: Financial system helps decentralized decision making. According to Robert Merton, Interest rates and security prices are used by households or their agents in making their consumption-saving decisions and in choosing the portfolio allocations of their wealth. These same prices provide important signals to managers of firms in their selection of investment projects and financings.OVERVIEW OF INDIAN FINANCIAL SYSTEM Page 7

COLLEGE

S.T. GONSALO GARCIA

The money market offers short term credit financial instruments and the capital market offers both long term credit financial instruments and permanent ownership capital. Information pertaining to these instruments is readily made available to all financial investors so that they can determine their portfolio allocations based on their risk taking abilities and understanding of the financial markets. Given the information on financial markets, households may decide on the distribution of their incomes between consumption and savings.

5) DEALING WITH THE PROBLEMS OF INCENTIVES: When financial information is not equally available to all, the problem of informational asymmetry or inequality comes into existence. This leads to the problems of moral hazard and adverse selection. These problems are known as agency problems. Ex. A person who has insured his car will become negligent and park his or her car without looking at the security aspects. This is very much true in a country like India where thousands of cars are parked in public spaces not earmarked for car parking for want of car parking facilities. This is the moral hazard faced by the insurance company. A person who is more likely to experience car loss arising out of car theft is most likely to take car insurance. This is the adverse selection problem faced by the insurance company.

OVERVIEW OF INDIAN FINANCIAL SYSTEM

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COLLEGE

S.T. GONSALO GARCIA

CHAPTER 2.FINANCIAL CONCEPTS:An understanding of the financial system requires an understanding of the following important concepts: Financial assets Financial intermediaries Financial markets Financial rates of return Financial instruments

2.1 FINANCIAL ASSETS:In any financial transaction, there should be a creation or transfer of financial asset. Hence, the basic product of any financial system is the financial

OVERVIEW OF INDIAN FINANCIAL SYSTEM

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COLLEGE

S.T. GONSALO GARCIA

asset. A financial asset is one which is used for production or consumption or for further creation of assets. Ex. A buys equity shares and these shares are financial assets since they earn income in future. In this context, one must know the distinct