• The financial system of a country means a set of financial arrangements by which the savings in the economy are mobilized for investment in productive assets.

• The financial system deals with all types of finance, agricultural, industrial, developmental and governmental finance.

• The suppliers and users of funds are a part of the financial system.

• Thus, the financial system is concerned with borrowing and lending of funds or the demand and supply of funds of all individuals, institutions, companies and the Government.

Meaning of Financial System

Financial System• Financial system ensures effective linkage between

financial savings and financial investment and management of liquidity.

• Financial system has witnessed evolution of money, financial institutions, financial markets and services.

• Banking is a part of the financial system.

Constituents of the Financial System

1. Financial Markets: Provide facilities for raising long term and short term funds.

2. Financial Institutions: Serve as intermediaries between borrowers and lenders of funds.

3. Financial Instruments: Are used to raise funds in the financial markets

4. Financial Services: Services offered by various financial institutions.

Financial Institutions• Includes institutions and mechanisms which–help generation of savings by the economy–Mobilisation of savings– Effective allocation of savings

• Institutions are banks, insurance companies, mutual funds

• Participants are individual investors, industrial and trading companies- borrowers

Financial Market

Money Markets:• Money Markets refer to the market for borrowing and

lending of funds. They provide facilities for liquidity adjustment.

Capital Market: A capital market is defined as the market for borrowing and lending for raising of capital for the purpose of investment. Capital market is a market where securities issued by firms (ie shares, bonds and debentures) can be bought and sold freely.

The demand for capital comes from business firms, agriculture and Government while the supply of capital is provided by individual savers, corporate savings.

Financial Markets

• Money Market- for short-term funds (less than a year)– Organised (Banks)– Unorganised (money lenders, chit funds, etc.)

• Capital Market- for long-term funds– Primary Issues Market– Stock Market– Bond Market

Money Market Instruments

• Call money- money borrowed/lent for a day. No collateral is required.

• Inter-bank term money- Borrowings among banks for a period of more than 14 days

• Treasury Bills- short term instruments issued by the Union Govt. to raise money.

• Certificates of Deposit- Neg Instr. issued by banks to raise money for 7 days to 1 year. Minimum value is Rs. 1 lakh, tradable in the market. CDs can be issued by banks/Fis

Money Market Instruments (2)

• Commercial Paper (CPs) – Issued by corporate of high credit ratings.

• Issued in multiple of 5 lakhs, can be issued by companies with a net worth of at least 4 crores

• CP is an unsecured promissory note privately placed with investors at a discount rate to face value. The maturity of CP is between 7days and 1year

Ready Forward Contracts (Repos)

• Repo (repurchase agreement) instruments enable collateralised short-term borrowing through the selling of debt instruments

• A security is sold with an agreement to repurchase it at a pre-determined date and rate

• Reverse repo is a mirror image of repo and reflects the acquisition of a security with a simultaneous commitment to resell

Call money market (1)

• It deals with one-day loans (overnight, to be precise) called call loans or call money

• Participants are mostly banks. Also called inter-bank call money market.

• The borrowing is exclusively limited to banks, who are temporarily short of funds.

• On the lending side, besides banks with excess cash participants are few FIs like LIC, UTI

• Deposits beyond 14 days are called inter bank term money

Call money market (2)

• Call loans are generally made on a clean basis- i.e. no collateral is required

• The main function of the call money market is to redistribute the pool of day-to-day surplus funds of banks among other banks in temporary deficit of funds

• The call market helps banks economise their cash and yet improve their liquidity

• It is a highly competitive and sensitive market• It acts as a good indicator of the liquidity position

Bill Market• Treasury Bill market- Also called the T-Bill market

– These bills are short-term liabilities (91-day and 364-day) of the Government of India

– It is an IOU of the government, a promise to pay the stated amount after expiry of the stated period from the date of issue

– They are issued at discount to the face value and at the end of maturity the face value is paid

– The rate of discount and the corresponding issue price are determined through auction for each issue

• Commercial Bill market- Not as developed in India as the T-Bill market

Capital MarketsThe capital market is classified into:• Primary Market: The primary market or the new

issues market refers to the raising of new capital by the issue of new shares, debentures and bonds.

• Secondary Market: The secondary market or the stock exchange is the market for old or already issued securities. It comprises of the stock market in which industrial securities are bought and sold.

The capital market serves a very useful purpose by pooling the capital resources of the country and making them available to the enterprising investors.

• Well developed capital markets augment resources by attracting and lending funds on a global scale.

What do banks do for their customers?

• Payments– These services include financial transactions,

including cheque accounts, credit cards, electronic banking (CHIPS or Clearing House Interbank Payments System), wire transfers (Fedwire), international payments (SWIFT or Society for Worldwide Interbank Financial Telecommunication), etc.

– Retail payments system and large payments system for business and government

What do banks do for their customers?• Financial intermediation:– Deposit function of offering savers a wide variety of

deposits, interest rates, and maturities and a high degree of liquidity.

– Loan function of transferring or allocating savings to most productive and profitable uses to provide growth and stability of the economy.

– Other financial services include off-balance sheet risk taking (from financial derivatives and guarantees), insurance-related activities, securities-related services, and trust services.

Why do banks perform those services?• Banks are private firms with a public purpose. They

seek to maximize shareholder wealth (represented by the market value of bank stock and dividends paid).

• Banking is the management of risk. By taking risks, they earn a profit.-- Credit risk -- Foreign exchange risk-- Interest rate risk -- Compliance risk-- Liquidity risk -- Strategic risk-- Price risk -- Reputation risk

• Various factors that affect banks include include market, social, and legal and regulatory constraints.

What factors have affected the operations of commercial banks

• Inflation and volatile interest rates:– Rising interest rates caused shorter-term deposit costs

to rise faster than longer-term loans. Also, as rates rose, the market value of their assets declined and borrowers defaulted on loans with greater frequency than normal.

• Securitization:– Banks are pooling loans for various kinds and selling

securities with claims on these loans. • Technological advances:– Telecommunications and computers are increasing

economies of scale and economies of scope for banks.