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The Financial System &
Financial Services
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Functions of the Financial System
A good financial system is a complex, well-integrated setof sub-systems of financial institutions, markets,instruments and services which facilitates the transferand allocation of funds, efficiently and effectively.
Payment system for the exchange of goods and services Pooling of resources for undertaking different types of
enterprises
Transfer of resources leading to efficient allocation ofphysical capital. This will include an efficient smooth
functioning capital market. A well developed financial system enables economicagents to pool, price and exchange risk. This includesderivatives.
It generates information which supports decentralisedand efficient decision making
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A Good Financial System
Financial markets reduce the cost of transactingincluding search costs and information costs. Searchcosts include explicit costs such as the expensesincurred on advertising when one wants to buy or sell asecurity, while implicit costs include the time and effortput in to locate a customer. Information costs refer tocosts incurred in evaluating the investment merits offinancial assets.
Often in developing economies, an Informal FinancialSystem co-exists with the Formal Financial System. Theinformal system is unorganized and unregulated, but
serves the traditional/ rural segments of the economy. Proponents of the market system argue that efficiency is
associated with the functioning of competitive financialmarkets. On the other hand, such markets are prone toinstability, with investors being exposed to market risks.
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Characteristics of Financial Markets
Large volume of transactions and the speed atwhich financial resources move from one marketto another
There is scope for arbitrage between variousmarkets and types of instruments
Financial markets are highly volatile and widespread panic/ distress selling can take place onaccount of the behaviour of a limited group of
operators Markets are usually dominated by financial
intermediaries who take investment decisions aswell as risks on behalf of depositors/ investors.
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Classification of Financial Markets
Nature ofClaims: Debt vs Equity Markets
Maturity ofClaim: Money Market vs CapitalMarket
Type ofClaim: Primary Market vs SecondaryMarket
Timing of Delivery: Cash or Spot Market vsForward or Futures Market
Organisational Structure: Exchange-traded vsOver-the-counter Market
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Financial Market Returns
Interest Rates:
An interest rate is a rate of return promised bythe borrower to the lender.
The interest rate return depends upon a varietyof factors including the unit of account, thematurity, and the default risk.
Rates of Return on Equity:
In the case of equity shares, the rates of returnare two: the cash dividend and the capitalgain/loss.
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Rates of Return on Risky Assets
Suppose you buy a share of a companys equity at a price of Rs.100. After one year you get a dividend of Rs. 5 and the share pricerise to Rs.115. Your one year return is:
Cash dividend Ending Price Beginning price
r = ----------------------- + ------------------------------------------Beginning price Beginning price
5 115 - 100
= ------ + -------------
100 100
= 5% + 15% = 20%The first component is called the dividend income component (ordividend yield) and the second component is called the capitalchange component (or capital yield). Often the two components maybe taxed differently.
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Determinants of Rates of Return
Inflation and Real Rates of Return: To make meaningful economic comparisons over time,
the prices of goods and services should be corrected forthe effects of inflation.
Similarly, a distinction can be made between nominal
and real rates of interest.The principal factors that determine the rates of return ina market economy are:
Expected productivity of capital: capital resources,comprising tangible capital and intangibles, help in
producing goods and services Degree of uncertainty characterising the productivity of
capital: in general higher the degree of uncertainty aboutthe productivity of capital, higher the risk premiumrequired by investors
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Determinants of Rates of Return
Time preferences of people: People prefercurrent consumption to future consumption.Other things being equal, the greater the
preference of the society for currentconsumption, the higher the interest rate in theeconomy and vice versa.
Degree of risk aversion: The financial system
splits the uncertain return on capital into twobroad components: a risk free return earned ondebt securities and a risky return earned onequity securities.
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Equilibrium in Financial Markets
At the equilibrium price, the supply and demand ofloanable funds are matched. This is the equilibriuminterest rate.
However, interest rates are often not determined bymarket forces.
At present, in India, the savings rate of interest ofcommercial banks, loans to weaker sections, rates ofinterest payable on small savings schemes are fixed bythe government.
The major criticism against the administered fixing of
prices is that the interest rates do not adequatelyperform the role of allocating scarce resources in aneconomy between alternative uses.
On the other hand, administered interest rates mayprotect vulnerable sections of society like the poor andthe elderly.
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Risk Return Relationship of Different
Financial Instruments
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Money Market
A money market is a market for short-term debtinstruments (maturity below one year). It is a highlyliquid market wherein securities are bought and sold inlarge denominations to reduce transaction costs. Thefunctions of a money market are:
To serve as an equilibrating force that redistributes cashbalances in accordance with the liquidity needs of theparticipants;
To form a basis for the management of liquidity andmoney in the economy by monetary authorities; and
To provide a reasonable access to the users of short-term money market for meeting the requirements atrealistic prices
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The Indian Money Market
Money Market Centres:
There are money market centres at Mumbai,Delhi and Kolkata, with Mumbai being the maincentre.
Money Market Instruments:
Treasury Bills (T-bills)
Call/ notice money market Call (overnight) andshort notice (up to 14 days)
Commercial Paper (CP)
Certificates of Deposit (CD)
Commercial Bills (CB)
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Capital Market
A capital market is a market for long-term securities(equity and debt). The purpose of the capital market isto:
Mobilize long-term savings to finance long-term
instruments; Provide risk-capital in the form of equity or quasi-equityto entrepreneurs;
Encourage broader ownership of productive assets;
Provide liquidity with a mechanism enabling the investor
to sell financial assets; Lower the costs of transactions and information; and
Improve the efficiency of capital allocation through acompetitive pricing mechanism
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Capital Market
A capital market can be further classified into
primary and secondary markets.
The primary market is meant for new issues and
the secondary market is a market whereinoutstanding issues are traded.
Basically, the primary market creates long-term
instruments for raising funds, whereas the
secondary market provides liquidity through the
marketability of these instruments.
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Rationale for Financial Intermediaries
Financial intermediaries can include commercial
banks, development financial institutions,
insurance companies, mutual funds, non-
banking finance companies, etc. They lead to: Portfolio Diversification
Lower Transaction Cost
Economics of Scale Confidentiality
Signalling
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The Financial System
Financial Institutions
Commercial Banks
Insurance Companies
Mutual Funds
Provident/ Pension Funds
NBFCs
Suppliers of Funds
Individuals
Businesses
Governments
Transfer Mechanisms
Public Issue
Private Placement
Instruments: Shares,
Loans, Securities
Demanders of Funds
Individuals
Businesses
Governments
Financial Markets
Money Market
Capital Market
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Indian Financial System
Formal Financial System InformalFinancial
System
Regulators Financial
Institutions
(Intermediaries)
Financial
Markets
Financial
Instruments
Financial
Services
Money
Lenders
Local
Bankers
Traders
Landlords
Pawn
Brokers
Ministry of
Finance
SEBI
RBI
IRDA
PensionRegulator
Banking
Institutions
Non-Banking
Institutions
Mutual Funds
Insurance Cos.
Housing Fin.
Cos.
Capital
Market
Money
Market
Term (Short,
Medium, Long
Term)
Type (Primary
& Secondary
incl. Equity,
Preference,Debt), Time
deposits, MF
units,
Insurance
policies
Depositories
Custodial
Credit rating
Factoring
Forfaiting
MerchantBanking
Leasing
Hire Purchase
Portfolio Mng.
Underwriting
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Financial Institutions (Intermediaries)
Banking Institutions Non-Banking Institutions
Scheduled
Commercial
Banks
Scheduled
Co-operative
Banks
Non-
Banking
Finance
Companies
Development
Financial Institutions
Public Sector
Private Sector
Foreign Banks
Regional Rural
Banks
All India Financial
Institutions
(IIFCL, IDFC, IFCI,
PFC, SIDBI,
NABARD, EXIM
Bank, NHB)
State Level
Institutions (SFCs,
SIDCs)
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Financial Markets
Capital Market Money Market
Equity Market Debt Market Treasury Bills
Call Money Market
C
ommercial BillsCommercial Paper
Certificates of
Deposit
Primary Market
(Public Issues, PrivatePlacement)
Secondary Market
(NSE, BSE, OTCEI,
Regional SEs)
Derivatives Market Exchange Traded
(Futures and Options)
Private Corporate
DebtPSU Bond Market
Government
Securities Market
(Primary Segment,
Secondary Segment)
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Financial Savings of Household
Sector (Gross)
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Regulatory Infrastructure
Ministry of Finance
Reserve Bank of India
Securities Exchange Board of India
Insurance Regulatory and Development
Authority
The Pension Fund Regulatory and Development
Authority
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Role of Reserve Bank of India
Provides currency and operates the clearing system forthe banks
Formulates the monetary and credit policies
Functions as the bankers bank
Supervises the operations of credit institutions
Regulates foreign exchange transactions
Moderates the fluctuations in the exchange value of therupee
Other functions: extension of the commercial bankingsystem in the rural areas; influences the allocation ofcredit; and promotes the development of new institutions
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Role of SEBI
Regulates the business in stock exchanges and anyother securities markets
Registers and regulates the capital marketintermediaries (brokers, merchant bankers, portfolio
managers, etc.) Registers and regulates the working of mutual funds
Prohibits fraudulent and unfair trade practices insecurities markets
Promotes investors education and training of
intermediaries of securities markets Prohibits insider trading in securities
Regulates substantial acquisition of shares andtakeovers of companies
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Some Trends
The Indian financial system is fairly integrated, stableand efficient.
Since the early 1990s a number of reforms measureshave been undertaken to improve the system.
Improvement in supervision of financial institutions by
RBI More freedom to commercial banks and strengthening of
their equity
Decreasing role of development financial institutions onaccount of non-access to SLR funds
Opening up the insurance sector to private players Important role being played by Foreign Institutional
Investors (FIIs) in equity market
Derivative instruments have been introduced
The Indian financial system is getting integrated with the
world financial system
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Reforms in the Financial System
Problem areas include:
Increase in fiscal deficit leading to huge issue ofgovernment debt. The Government had been trying tobring this under control with the passage of the Fiscal
Responsibility and Budget Management Act (FRBMA)which sought to eliminate revenue deficits by 2008-09.On account of the global financial meltdown, thereduction of fiscal deficit target has been postponed.
Volatility in financial markets
Low tradability of corporate bond market
Absence of yield curve
Scams in areas like stock markets, co-operative banks,etc.
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Introduction to Financial
Services
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Financial Services
Financial services are services that ensure the smoothflow of financial activities in the economy. It includingbanking, insurance, stock broking and investmentservices as well as business and professional services. Itincludes services offered by both Asset Managementcompanies.
Financial Services help to raise required funds but alsoensure their efficient deployment. To ensure an efficientmanagement of funds, services such as bill discounting,factoring of debtors, parking of short term funds in
money market, e-commerce and securitization of debtsare provided by financial service firms. Services includecredit rating, lease financing, factoring, venture capital,mutual funds, merchant banking, stock lending,depository services, housing finance, etc.
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Characteristics of Financial Services
Customer-Specific: Focused, fulfill need of the customer,with due regard to cost, liquidity and maturityconsideration
Intangibility: Quality and innovativeness of services to
build up credibility of service delivery The need to produce and deliver new and innovativefinancial services. Financial products are comparativelyeasy to replicate; so need to differentiate on servicestandards.
People centric industry and hence subjected to variabilityof performance or quality of service.
Market Dynamics: Constantly redefined and refinedtaking into consideration of various dynamics in financialservices.
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Types of Financial Services
Financial services industry could be classified under three broadcategories: Fee Based services, Fund Based services andInsurance Services
Fee Based Services :
Financial institutions operating in specialized fields earn a
substantial income by way of fees, commission, discount andbrokerage on operations. These services include Issue ManagementServices, Corporate Advisory Services, Credit Rating, Mutual Fundsbusiness, Assets Securitization, etc.
Fund Based Services :
Firms raise funds through equity, debt, and deposits and investsthese funds in securities or lends to those who are in need of capital.Such firms include Banks, Leasing and Hire Purchase Companies,Housing Finance Companies, Issuers ofCredit Cards, VentureCapital funds, Factoring, Forfaiting and Bill Discounting.
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