management of financial institutionstitutions

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OVERVIEW OF FINANCIAL INSTITUTIONLESSON 1:INTRODUCTION TO INDIAN FINANCIAL

SYSTEM

Learning ObjectivesAfter reading this lesson, you will understand Significance and definition of financial system Importance Of Financial Institutions Role Of Financial Intermediaries Financial System Various Types Of Classification Functions Of Financial InstitutionDear students, today is our first lecture on Management ofFinancial Institution. Before we get deep into the subject, theprimary basic thing for us to understand is the significance, role,importance and function of financial institution.

What is the Significance and Definition of Financial

System?We all know that the growth of output in any economydepends on the increase in the proportion of savings/investment to a nations output of goods and services. So thefinancial system and financial institutions help in the diversionof rising current income into savings/investments.We can define financial system as a set of institutions,instruments and markets, which foster savings and channelsthem to their most efficient use. The system consists ofindividuals (savers), intermediaries, markets and users ofsavings. Economic activity and growth are greatly facilitated bythe existence of a financial system developed in terms of theefficiency of the market in mobilising savings and allocatingthem among competing users.Well-developed financial markets are required for creating abalanced financial system in which both financial markets andfinancial institutions play important roles. Deep and liquidmarkets provide liquidity to meet any surge in demand forliquidity in times of financial crisis. Such markets are alsonecessary to derive appropriate reference rates for pricingfinancial assets.This lesson introduces the financial intermediary. Intermediariesinclude commercial banks, savings and loan associations,investment companies, insurance companies, and pensionfunds. The most important contribution of intermediaries is asteady and relatively inexpensive flow of funds from savers tofinal users or investors. Every modern economy hasintermediaries, which perform key financial functions forindividuals, households, corporations, small and newbusinesses, and governments.

What is the Importance of Financial Institutions?Now coming to the importance of Financial Institution that i.e.why is financial intermediaries so important in any country orfor that matter in any economy. The answer is simple. Businessentities include non-financial and financial enterprises. Non-

financial enterprises manufacture products (e.g., cars, steel,computers) and/or provide non-financial services (e.g.,transportation, utilities, computer programming). Financialenterprises, more popularly referred to as financialinstitutions, provide services related to one or more of thefollowing: let us see what are those. Transforming financial assets acquired through the market

and constitution them into a different, and more widelypreferable, type of asset-which becomes their liability. This isthe function performed by financial intermediaries, themost important type of financial institution.

Exchanging of financial assets on behalf of customers. Exchanging of financial assets for their own accounts. Assisting in the creation of financial assets for their

customers, and then selling those financial assets to othermarket participants.

Providing investment advice to other market participants. Managing the portfolios of other market participants.So now you are aware that financial intermediaries includedepository institutions (commercial banks, savings and loanassociates, savings banks, and credit unions), which acquire thebulk of their funds by offering their liabilities to the publicmostly in the form of deposits: insurance companies (life andproperty and casualty companies); pension funds; and financecompanies.

What are the Role of Financial Intermediaries?Financial intermediaries obtain funds by issuing financial claimsagainst themselves to market participants, and then investingthose funds; the investments made by financial intermediaries-their assets- can be in loans and/or securities. Theseinvestments are referred to as direct investments. Marketparticipants who hold the financial claims issued by financialintermediaries are said to have made indirect investments.We can elaborate this further by understanding that financialinstitutions are business organisations that act as mobilisersand depositories of savings, and as purveyors of credit orfinance. They also provide various financial services to thecommunity. They differ from non-financial (industrial andcommercial) business organisations in respect of their dealings,i.e., while the former deal in financial assets such as deposits,loans, securities, and so on, the latter deal in real assets such asmachinery, equipment, stocks of goods, real estate, and so on.You should not think that the distinction between the financialsector and the real sector is something ephemeral orunproductive about finance. At the same time, it means that therole of financial sector should not be overemphasised. Theactivities of different financial institutions may be eitherspecialised or they may overlap; quite often they overlap. Yet you

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need to classify financial institutions and this is done on thebasis of their primary activity or the degree of theirspecialisation with relation to savers or borrowers with whomthey customarily deal or the manner of their creation. In otherwords, the functional, geographic, sectoral scope of activity orthe types of ownership are some of the criteria, which are oftenused to classify a large

Financial System Various Types of ClassificationWe can classify financial institutions into banking and non-banking institutions. You know that the banking institutionshave quite a few things in common with the non-banking ones,but their distinguishing character lies in the fact that, unlikeother institutions, they participate in the economys paymentsmechanism, i.e., they provide transactions services, their depositliabilities constitute a major part of the national money supply,and they can, as a whole, create deposits or credit, which ismoney. Banks, subject to legal reserve requirements, can advancecredit by creating claims against themselves, while otherinstitutions can lend only out of resources put at their disposalby the savers, and the latter as mere purveyors of credit.While the banking system in India comprises the commercialbanks and co-operative banks, the examples of non-bankingfinancial institutions are Life Insurance Corporation (LIC), UnitTrust of India (UTI), and Industrial Development Bank ofIndia (IDBI). We shall discuss this in detail later.There are also few other ways to classify financial institution.Like they can be classified as intermediaries and non-intermediaries. As we have seen earlier, intermediariesintermediate between savers and investors; they lend money aswell as mobilise savings; their liabilities are towards the ultimatesavers, while their assets are from the investors or borrowers.Non--intermediary institutions do the loan business but theirresources are not directly obtained from the savers. All bankinginstitutions are intermediaries. Many non-banking institutionsalso act as intermediaries and when they do so they are knownas Non-Banking Financial Intermediaries (NBFI) . UTI,LIC, General Insurance Corporation (GIC) is some of theNBFIs in India. Non-intermediary institutions like IDBI,Industrial Finance Corporation (IFC), and National Bank forAgriculture and Rural Development (NABARD) have comeinto existence because of governmental efforts to provideassistance for specific purposes, sectors, and regions. Theircreation as a matter of policy has been motivated by thephilosophy that the credit needs of certain borrowers might notbe otherwise adequately met by the usual private institutions.Since they have been set up by the government, we can call themNon-Banking Statutory Financial Organisations (NBSFO).Let us now shift our focus to financial markets. Financialmarkets are the centers or arrangements that provide facilitiesfor buying and selling of financial claims and services. Thecorporations, financial institutions, individuals andgovernments trade in financial products in these markets eitherdirectly or through brokers and dealers on organised exchangesor off--exchanges. The participants on the demand and supplysides of these markets are financial institutions, agents, brokers,dealers, borrowers, lenders, savers, and others who are

interlinked by the laws, contracts, covenants andcommunication networks.Financial markets are sometimes classified as primary (direct)and secondary (indirect) markets. You all must be well awarethat primary markets deal in the new financial claims or newsecurities and, therefore, they are also known as new issuemarkets. On the other hand, secondary markets deal in securitiesalready issued or existing or outstanding. The primary marketsmobilise savings and supply fresh or additional capital tobusiness units. Although secondary markets do not contributedirectly to the supply of additional capital, they do so indirectlyby rendering securities issued on the primary markets liquid.Stock markets have both primary and secondary marketsegments.Very often financial markets are classified as money marketsand capital markets, although there is no essential differencebetween the two as both perform the same function oftransferring resources to the producers. This conventionaldistinction is based on the differences in the period of maturityof financial assets issued in these markets. While moneymarkets deal in the short-term claims (with a period of maturityof one year or less), capital markets do so in the long-term(maturity period above one year) claims. Contrary to popularusage, the capital market is not only co-extensive with the stockmarket; but it is also much wider than the stock market.Similarly, it is not always possible to include a given participantin either of the two (money and capital) markets alone.Commercial banks, for example, belong to both. While treasurybills market, call money market, and commercial bills market areexamples of money market; stock market and governmentbonds market are examples of capital market.The above classification can be tabulated in the table format asgiven below:Table 1

Classification by nature of claim: Debt Market Equity Market Classification by maturity of claim: Money Market Capital Market Classification by seasoning of claim : Primary Market Secondary Market Classification by immediate delivery or future delivery: Cash or spot Market Derivative Market Classification by organizational structure: Auction Market Over -the-counter Market Intermediated Market

What are the points of difference related to financialinstruments? These instruments differ from each other inrespect of their investment characteristics, which of course, areinterdependent and interrelated. Among the investmentcharacteristics of financial assets or financial products, thefollowing are important: (i) liquidity, (ii) marketability, (iii)reversibility, (iv) transferability, (v) transactions costs, (vi) risk ofdefault or the degree of capital and income uncertainty, and awide array of other risks, (vii) maturity period, (viii) tax status,

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N(ix) options such as call-back or buy-back option, (x) volatilityof prices, and (xi) the rate of return-nominal, effective, and real.

What are the Functions of Financial Institution?After a detailed discussion on financial institution it becomeseasy for us to determine the functions of financial institution.Financial institutions or intermediaries offer various types oftransformation services. They issue claims to their customersthat have characteristics different from those of their ownassets. For example, banks accept deposits as liability andconvert them into assets such as loans. This is known asliability-asset transformation function. Similarly theychoose and manage portfolios whose risk and return they alterby applying resources to acquire better information and toreduce or overcome transaction costs. They are able to do sothrough economies of scale in lending and borrowing. Theyprovide large volumes of finance on the basis of small depositsor unit capital. This is called size-transformation function.Further, they distribute risk through diversification and therebyreduce it for savers as in the case of mutual funds. This is calledrisk-transformation function. Finally they offer saversalternate forms of deposits according to their liquiditypreferences, and provide borrowers with loans of requisitematurities. This is known as maturity-transformationfunction.A financial system also ensures that transactions are effectedsafely and swiftly on an on-going basis. It is important thatboth buyers and sellers of goods and services should have theconfidence that instruments used to make payments will beaccepted and honoured by all parties. The financial systemensures the efficient functioning of the payment mechanism.In a nutshell, financial markets can be said to performproximate functions such as1. Enabling economic units to exercise their time preference,2. Separation, distribution, diversification, and reduction of

risk,3. Efficient operation of the payment mechanism,4. Transmutation or transformation of financial claims so as to

suit the preferences of both savers and borrowers,5. Enhancing liquidity of financial claims through securities

trading, and6. Portfolio management.

Questions to Discuss1. What is the Significance And Definition of Financial System?2. What is the Importance Of Financial Institutions?3. What is the Role Of Financial Intermediaries?4. What are the various classifications of Financial Institutions?5. What are the functions of Financial Institutions?

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LESSON 2:INTRODUCTION TO INDIAN FINANCIAL SYSTEM

Learning ObjectivesAfter reading this lesson, you will understand Maturity Intermediation Reducing Risk Via Diversification Reducing The Costs Of Contracting And Information

Processing Providing A Payments Mechanism Asset/ Liability Management Of The Financial Institutions Nature Of Liabilities Liquidity Concerns Brokerage and asset transformation Advantages of financial institutions Criteria To Evaluate Financial InstitutionsAfter getting aware of the characteristics of financial institution,let us understand some other related concepts.

What do you Mean by Maturity Intermediation?The commercial bank by issuing its own financial claims inessence transforms a longer-term asset into a shorter-term oneby giving the borrower a loan for the length of time sought andthe investor/depositor a financial asset for the desiredinvestment horizon. This function of a financial intermediary iscalled maturity intermediation.You should understand that maturity intermediation has twoimplications for financial markets. First, it provides investorswith more choices concerning maturity for their investments;borrowers have more choices for the length of their debtobligations. Second, because investors are naturally reluctant tocommit funds for a long period of time, they will require thatlong-term borrowers pay a higher interest rate than on short-term borrowing. A financial intermediary is willing to makelonger-term loans, and at a lower cost to the borrower than anindividual investor would, by counting on successive depositsproviding the funds until maturity. Thus, the secondimplication is that the cost of longer-term borrowing is likely tobe reduced.

What is Reducing Risk Via Diversification?Next shall discuss the way to reduce the risk throughdiversification. Consider the example of the investor who placesfunds in an investment company. Suppose that the investmentcompany invests the funds received in the stock of a largenumber of companies. By doing so, the investment companyhas diversified and reduced its risk. Investors who have a smallsum to invest would find it difficult to achieve the same degreeof diversification because they do not have sufficient funds tobuy shares of a large number of companies. Yet by investing inthe investment company for the same sum of money, investorscan accomplish this diversification, thereby reducing risk.

This economic function of financial intermediaries-transforming more risky assets into less risky ones- is calleddiversification. Although individual investors can do it on theirown, they may not be able to do it as cost-effectively as afinancial intermediary, depending on the amount of funds theyhave to invest. Attaining cost-effective diversification in order todeduce risk by purchasing the financial assets of a financialintermediary is an important economic benefit for financialmarkets.

Reducing the Costs of Contracting and Information

ProcessingYou can also reduce the cost of contracting and informationprocessing. Suppose you are an investor purchasing financialassets. You should take the time to develop skills necessary tounderstand how to evaluate an investment. Once these skills aredeveloped you should apply them to the analysis of specificfinancial assets that are candidates for purchase (or subsequentsale). If you as an investor wants to make a loan to a consumeror business you will need to write the loan contract.Although there are some people who enjoy devoting leisuretime to their task, most prefer to use that time for just that-leisure. Most of us find that leisure time is in short supply, soto sacrifice it, we have to be compensated; the form ofcompensation could be a higher return that we obtain from aninvestment.In addition to the opportunity cost of the time to process theinformation about the financial asset and its issuer, there is thecost of acquiring that information. All these costs are calledinformation processing costs. The costs of writing loancontracts are referred to as contracts are referred to as contractingcosts. There is also another dimension to contracting costs, thecost of enforcing the terms of the loan agreement.With this in mind, consider the two examples of financialintermediaries- the commercial bank and the investmentcompany. People who work for these intermediaries includeinvestment professionals who are trained to analyse financialassets and manage them. In the case of loan agreements, eitherstandardised contracts can be prepared, or legal counsel can bepart of the professional staff that writes contracts involvingmore complex transactions. The investment professional canmonitor compliance with the terms of the loan agreement andtake any necessary action to protect the interests of the financialintermediary. The employment of such professionals is cost-effective for financial intermediaries because investing funds istheir normal business.In other words, there are economies of scale in contracting andprocessing information about financial assets because of theamount of funds managed by financial intermediaries. Thelower costs accrue to the benefit of the investor who purchases

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Na financial claim of the financial intermediary and to the issuersof financial assets, who benefit from a lower borrowing cost.

Providing a Payments MechanismYou have seen that most transactions made today are not donewith cash. Instead, payments are made using cheques, creditcards, and electronic transfers of funds. These methods formaking payments are provided by certain financialintermediaries.At one time, non-cash payments were restricted to chequeswritten against non-interest-bearing accounts at commercialbanks. Similar check writing privileges were provided later bysavings and loan associations and saving banks, and by certaintypes of investment companies. Payment by credit card was alsoone time the exclusive domain of commercial banks, but nowother depository institutions offer this service. Debit cards areoffered by various financial intermediaries. I am sure all of uspresent over here must be having at least one debit card apartfrom credit cards. And you all must also be aware that a debitcard differs from a credit card in that, in the latter case, a bill issent to the credit card holder periodically (usually once a month)requesting payment for transactions made in the past. In thecase of a debit card, funds are immediately withdrawn (that is,debited) from the purchasers account at the time the transactiontakes placeThe ability to make payments without the use of cash is criticalfor the functioning of a financial market. In short, depositoryinstitutions transform assets that cannot be used to makepayments into other assets that offer that property.

Asset/ Liability Management of the Financial

InstitutionsTo understand the reasons mangers of financial institutionsinvest in particular types of financial assets and the types ofinvestment strategies they employ, it is necessary that you have ageneral understanding of the asset/ liability problem faced.The nature of the liabilities dictates the investment strategy afinancial institution will pursue. For example, depositoryinstitutions seek to generate income by the spread between thereturn that they earn on assets and the cost of their funds. Thatis, they buy money and sell money. They buy money byborrowing from depositors or other sources of funds. They sellmoney when they lend it to businesses or individuals. Inessence, they are spread businesses. Their objective is to sellmoney for more than it costs to buy money. The cost of thefunds and the return on the funds sold is expressed in terms ofan interest rate per unit of time. Consequently, the objective ofa depository institution is to earn a positive spread between theassets it invests in (what it has sold the money for) and thecosts of its funds (what it has purchased the money for).Life insurance companies- and, to a certain extent, property andcasualty insurance companies- are in a spread business. Pensionfunds are not in the spread business in that they do not raisefunds themselves in the market. They seek to cover the cost ofpension obligations at a minimum cost that is borne by thesponsor of the pension plan. Investment companies face noexplicit costs for the funds they acquire and must satisfy nospecific liability obligations; one exception is a particular type of

investment company that agrees to repurchase shares at anytime.

Nature of LiabilitiesBy the liabilities of the financial institution we mean theamount and timing of the cash outlays that must be made tosatisfy the contractual terms of the obligations issued. Theliabilities of any financial institution can be categorizedaccording to four typed as shown in the below table. Thecategorisation in the table assumes that the entity that must bepaid the obligation will not cancel the financial institutionsobligation prior to any actual or projected payout date.The descriptions of cash outlays as either known or uncertainare undoubtedly broad. When you refer to a cash outlay asbeing uncertain, you do not mean that it cannot be predicted.There are some liabilities where the law of large numbersmakes it easier to predict the timing and/or amount of cashoutlays. This is the work typically done by actuaries, but ofcourse even actuaries cannot predict natural catastrophes such asfloods and earthquakes.Table 2

Nature of Liabilities of Financial Institutions

Liability type Amount of Cash Outlay Timing of Cash Outlay

Type I Known Known

Type II Known Uncertain

Type III Uncertain Known

Type IV Uncertain Uncertain

Let us illustrate each one of them

Type I LiabilitiesBoth the amount and the timing of the liabilities are knownwith certainty. A liability requiring a financial institution to payRs.50, 000 six months from now would be an example. Forexample, depository institutions know the amount that they arecommitted to pay (principal plus interest) on the maturity dateof a fixed-rate deposit, assuming that the depositor does notwithdraw funds prior to the maturity date.

Type I Liabilitieshowever, are not limited to depository institutions. A majorproduct sold by life insurance companies is a guaranteedinvestment contract, popularly referred to as a GIC. Theobligation of the life insurance company under this contract isthat, for a sum of money (called a premium), it will guaranteean interest rate up to some specifies maturity date. For example,suppose a life insurance company for a premium of Rs.10million issues a five-year GIC agreement to pay 10%compounded annually. The life insurance company knows thatit must pay Rs16.11 million to the GIC policyholder in fiveyears.

Type II LiabilitiesThe amount of cash outlay is known, but the timing of thecash outlay is uncertain. The most obvious example of a TypeII liability is a life insurance policy. There are many types of lifeinsurance policies but the most basic type is that, for an annualpremium, a life insurance company agrees to make a specified

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dollar payment to policy beneficiaries upon the death of theinsured.

Type III LiabilitiesWith this type of liability, the timing of the cash outlay isknown, but the amount is uncertain. An example is where afinancial institution has issued an obligation in which theinterest rate adjusts periodically according to some interest ratebenchmark. Depository institutions, for example, issueaccounts called certificates of deposit, which have a statedmaturity, the interest rate paid need not be fixed over the life ofhe deposit but may fluctuate. If a depository institution issuesa three-year floating-rate certificate of deposit that adjusts everythree months and the interest rate paid is the three-monthTreasury bill rate plus one percentage point, the depositoryinstitution knows it has a liability that must be paid off in threeyears, but the dollar amount of the liability is not known. Itwill depend on three-month Treasury bill rates over the threeyears.

Type IV LiabilitiesThere are numerous insurance products and pensionobligations that present uncertainty as to both the amount andthe timing of the cash outlay. Probably the most obviousexamples are automobile and home insurance policies issued byproperty and casualty insurance companies. When, and if, apayment will have to be made to the policyholder is uncertain.Whenever damage is done to an insured asset, the amount ofthe payment that must be made is uncertain.

What are the Liquidity Concerns?By liquidity concerns what do you understand? Because of theuncertainty about the timing and/ or the amount of the cashoutlays, a financial institution must be prepared to havesufficient cash to satisfy its obligations. Here it has beenassumed that the entity that holds the obligation against thefinancial institution may have the right to change the nature ofthe obligation, perhaps incurring some penalty. For example, inthe case of a certificate of deposit, you as a depositor mayrequest the withdrawal of funds prior to the maturity date;typically, the deposit-accepting institution will grant this requestbut assess an early withdrawal penalty. In the case of certaintypes of investment companies, shareholders have the right toredeem their shares at any time.Some life insurance products have a cash-surrender value. Thismeans that, at specified dated, the policyholder can exchange thepolicy for a lump-sum payment. Typically, the lump-sumpayment will penalize the policyholder for turning in the policy.There are some life insurance products that have a loan value,which means that the policyholder has the right to borrowagainst the cash value of the policy.In addition to uncertainty about the timing and amount of thecash outlays, and the potential for the depositor of policyholderto withdraw cash early or borrow against a policy, a financialinstitution has to be concerned with possible reduction in cashinflows. In the case of a depository institution, this means theinability to obtain deposits. For insurance companies, it meansreduced premiums because of the cancellation of policies. For

certain types of investment companies, it means not being ableto find new buyers for shares.

Brokerage and Asset TransformationNow let us move ahead to discuss the services. Intermediaryservices are of two kinds, brokerage function and assettransformation activity. Brokerage function as represented bythe activities of brokers and market operators, processing andsupplying information is a part and parcel of all intermediationby all institutions. Brokerage function brings together lendersand borrowers and reduces market imperfections such as search,information and transaction costs. The asset transformationactivity is provided by institutions issuing claims againstthemselves, which differ, from the assets they acquire. Mutualfunds, insurance companies, banks and depositors with a shareof a large asset or issuing debt type liabilities against equity typeassets. While providing asset transformation, financial firmsdiffer in the nature of transformation undertaken and in thenature of protection or guarantees, which are offered. Banksand depository institutions offer liquidity, insurance againstcontingent losses to assets and mutual funds against loss invalue of assets.Through their intermediary activities banks provide a package ofinformation and risk sharing services to their customers. Whiledoing so they take on part of heir risk. Banks have to managethe risks through appropriate structuring of their activities andhedge risks through derivative contracts to maximize theirprofitability.Financial institutions provide three transformation services.Firstly, liability, asset and size transformation consisting ofmobilization of funds and their allocation (provision of largeloans on the basis of numerous small deposits). Secondly,maturity transformation by offering the savers the relativelyshort- term claim or liquid deposit they prefer and providingborrowers long-term loans which are better matched to the cashflows generated by their investment. Finally, risk transformationby transforming and reducing the risk involved in direct lendingby acquiring more diversified portfolios than individual saverscan. The expansion of the financial network or an increase infinancial intermediation as denoted by the ration of financialassets of all kinds of gross national product accompaniesgrowth. To a certain extent, growth of savings is facilitated bythe increase in the range of financial instruments and expansionof markets.

Finally What are the Advantages of Financial

Institutions?After discussing the financial institution now tell me studentsthat is there any advantage of financial institution at all. I amsure you all will have the same answer YES. Benefits providedby financial intermediaries consist of reduction of informationand transaction costs, grant long-term loans, and provide liquidclaims and pool risks. Financial intermediaries economise costsof borrowers and lenders. Banks are set up to mobilize savingsof many small depositors, which are insured. While lending,the bank makes a single expert investigation of the creditstanding of the borrower saving on several investigations ofamateurs.

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NFinancial intermediaries make it possible for borrowers toobtain long-term loans even though the ultimate lenders aremaking only short-term loans. Borrowers who wish to acquirefixed assets do not want to finance them with short-term loans.Although the bank has used depositors funds to make long-term loans it still promises its depositors that they canwithdraw their deposits at any time on the assumption that thelaw of large numbers will hold. Bank deposits are highly liquidand one can withdraw the deposit any time, though on somekinds of deposits the interest previously earned on it has to beforegone. Finally, banks by pooling the funds of depositorsreduce the riskness of lending. Indirect finance in some reducesthe information and transaction costs of lenders andborrowers, renders deposits liquid and reduces the risk oflending.The ability of the financial intermediaries to ensure the mostefficient transformation of mobilized funds into real capital hasnot, however, received the attention it deserves. Institutionalmechanisms to ensure end use of funds have not been efficientin their functioning, leaving the investor unprotected. Efficientfinancial intermediation involves reduction of the transactioncost of transferring funds from original sabers to financialinvestors. The total coat of intermediation is influenced byfinancial layering, which makes the individual institutions costsadditive in the total cost of intermediating between savers andultimate borrowers. The aggregate cost of financialintermediation from the original saver to ultimate investor ismuch higher in developing countries than in developedcountries.

Criteria to Evaluate Financial InstitutionsGiven the controversy regarding the contribution of financialsector, it is necessary to have a framework to evaluate theperformance of the countrys financial sector. Let us first look atthe criteria formulated, in the form of questions, by Richard D.Erb, the former Deputy Managing Director of the InternationalMonetary Fund: (i) Do institutions find the most productiveinvestments? (ii) Do institutions revalue their assets andliabilities in response to changed circumstances? (iii) Doinvestors and financial institutions expect to be bailed out ofmistakes and at what price? (iv) Do institutions facilitate themanagement of risk by making available the means to insure,hedge, and diversify risks? (v) Do institutions effectivelymonitor the performance of their users, and discipline thosenot making proper and effective use of their resources? (vi)How effective is the legal, regulatory, supervisory, and judicialstructure? (vii) Do financial institutions publish consistent andtransparent information?These criteria, useful as they are, do not encompass social andethical aspects of finance which ought to be regarded asimportant as economic aspects. Therefore, the relevantnormative criteria, organising principles, and value premiseswhich should guide the functioning of the financial system are: Finance is not the most critical factor in development. The use of finance must be imbued with the virtues of

austerity, self--limit, and minimisation.

Financial reforms are not merely a question of creditlimits; they encompass issues involved in limits of credit.

State intervention is not the best way to achieve a fairdistribution of credit.

Financial institutions must evolve from below rather than beimposed from above. Financial development ought to takeplace at a slow and steady pace rather than in spurts and in aprogrammed or (time) encapsulated manner.

There should be a replacement of large-scale by small-scale,wholesale by retail, and class by mass banking.

The sufficing principle rather than the maximising oneshould power the financial system. The functioning ofdifferent financial institutions must be on the basis of acommunitarian spirit, not competition and profit motive.

The financing of investment which results in thedisplacement or retrenchment of labour should bediscouraged.

The scope for financing various sectors is ultimatelyconstrained by domestic saving. The substantial increase inthe total saving in India is unlikely to take place now.

The working of the Indian financial system should not becorporate-sector-centric.

There are limits to the overall and industrial growth, and,therefore, a ceiling on the targeted rate of growth has to beimposed.

The only legitimate role of the financial markets isinfrastructural, hence they should not exist to provideopportunities to make quick, disproportionate pecuniarygains.

It is the primary markets activity of supporting new,economically and socially productive real investment, trade,and flows of goods and services, which is of foremostimportance. The enthusiasm, hyperactivity, andpreoccupation with the secondary markets ought to beavoided.

SummaryFinancial institutions provide various types of financial services.Financial intermediaries are a special group of financialinstitutions that obtain funds by issuing claims to marketparticipants and use these funds to purchase financial assets.Intermediaries transform funds they acquire into assets that aremore attractive to the public. By doing so, financialintermediaries do one or more of the following: (1) providematurity intermediation; (2) provide risk reduction viadiversification at lower cost; (3) reduce the cost of contractingand information processing; or (4) provide a paymentsmechanism.The nature of their liabilities determines the investment strategypursued by all financial institutions. The liabilities of allfinancial institution will generally fall into one of the four typesshown in Table 2.

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We shall discuss the classifications, roles, functions andadvantages of the financial institutions in detail in our laterlectures.

Questions to Discuss:1. What do you mean by Maturity Intermediation?2. What is Reducing Risk Via Diversification?3. What is the nature Of Liabilities?4. What are the Liquidity Concerns?5. What are the Advantages of financial institutions?6. What are the criteria To Evaluate Financial Institutions?

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LESSON 3:FINANCIAL SYSTEM AND ECONOMIC DEVELOPMENT

Learning objectivesAfter reading this lesson, you will understand Effects of financial system on saving and investment Relationship between financial system and economic

development A cautionary approach- The process of financial development Criteria to evaluate financial sectorStudents, today in the class let us discuss the correlation offinancial system and the economic development. The role offinancial system in economic development has been a much-discussed topic among economists. Is it possible to influencethe level of national income, employment, standard of living,and social welfare through variations in the supply of finance?In what way financial development is affected by economicdevelopment?There is no unanimity of views on such questions. A recentliterature survey concluded that the existing theory on thissubject has not given any generally accepted model to describethe relationship between finance and economic development.The importance of finance in development depends upon thedesired nature of development. In the environment-friendly,appropriate-technology-based, decentralised AlternativeDevelopment Model, finance is not a factor of crucialimportance. But even in a conventional model of modemindustrialism, the perceptions in this regard vary a great deal.One view holds that finance is not important at all. Theopposite view regards it to be very important. The third schooltakes a cautionary view. It may be pointed out that there is aconsiderable weight of thinking and evidence in favour of thethird view also. Let us briefly explain these viewpoints one byone.In his model of economic growth, Solow has argued thatgrowth results predominantly from technical progress, which isexogenous, and not from the increase in labour and capital.Therefore, money and finance and the policies about themcannot contribute to the growth process.

You All Tell Me What are your Opinions Regarding

this?

Effects of Financial System on Saving and InvestmentIt has been argued that men, materials, and money are crucialinputs in production activities. The human capital and physicalcapital can be bought and developed with money. In a sense,therefore, money, credit, and finance are the lifeblood of theeconomic system. Given the real resources and suitableattitudes, a well--developed financial system can contributesignificantly to the acceleration of economic developmentthrough three routes. First, technical progress is endogenous;

human and physical capital are its important sources and anyincrease in them requires higher saving and investment, whichthe financial system helps to achieve. Second, the financialsystem contributes to growth not only via technical progressbut also in its own right. Economic development greatlydepends on the rate of capital formation. The relationshipbetween capital and output is strong, direct, and monotonic(the position which is sometimes referred to as capitalfundamentalism). Now, the capital formation depends onwhether finance is made available in time, in adequate quantity,and on favourable terms-all of which a good financial systemachieves. Third, it also enlarges markets over space and time; itenhances the efficiency of the function of medium of exchangeand thereby helps in economic development.We can conclude from the above that in order to understand theimportance of the financial system in economic development,we need to know its impact on the saving and investmentprocesses. The following theories have analyzed this impact: (a)The Classical Prior Saving Theory, (b) Credit Creation or ForcedSaving or Inflationary Financing Theory, (c) Financial RepressionTheory, (d) Financial Liberalisation Theory.The Prior Saving Theory regards saving as a prerequisite ofinvestment, and stresses the need for policies to mobilise savingvoluntarily for investment and growth. The financial system hasboth the scale and structure effect on saving and investment. Itincreases the rate of growth (volume) of saving andinvestment, and makes their composition, allocation, andutilisation more optimal and efficient. It activises saving orreduces idle saving; it also reduces unfructified investment andthe cost of transferring saving to investment.How is this achieved? In any economy, in a given period oftime, there are some people whose current expenditures is lessthan their current incomes, while there are others whose currentexpenditures exceed their current incomes. In well-knownterminology, the former are called the ultimate savers orsurplus--spending-units, and the latter are called the ultimateinvestors or the deficit-spending-units.Modern economies are characterized (a) by the ever-expandingnature of business organisations such as joint-stock companiesor corporations, (b) by the ever-increasing scale of production,(c) by the separation of savers and investors, and (d) by thedifferences in the attitudes of savers (cautious, conservative, andusually averse to taking risks) and investors (dynamic and risk-takers). In these conditions, which Samuelson calls thedichotomy of saving and investment, it is necessary to connectthe savers with the investors. Otherwise, savings would bewasted or hoarded for want of investment opportunities, andinvestment plans will have to be abandoned for want ofsavings. The function of a financial system is to establish abridge between the savers and investors and thereby help themobilisation of savings to enable the fructification of

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investment ideas into realities. Figure below reflects this role ofthe financial system in economic development.

Relationship Between Financial System and

Economic Development

Economic Development

Savings & Investment or Capital Formation

Surplus Spending Economic Units

Deficit Spending Economic Units

Income Minus (Consumption + Own investment)

Income Minus (Consumption + Investment)

Surplus or Saving Deficit or Negative Saving

Financial System

A financial system helps to increase output by moving theeconomic system towards the existing production frontier. Thisis done by transforming a given total amount of wealth intomore productive forms. It induces people to hold less savingsin the form of precious metals, real estate land, consumerdurables, and currency, and to replace these assets by bonds,shares, units, etc. It also directly helps to increase the volumeand rate of saving by supplying diversified portfolio of suchfinancial instruments, and by offering an array of inducementsand choices to woo the prospective saver. The growth ofbanking habit helps to activise saving and undertake freshsaving. The saving is said to be institution-elastic i.e., easyaccess, nearness, better return, and other favourable featuresoffered by a well-developed financial system lead to increasedsaving.A financial system helps to increase the volume of investmentalso. It becomes possible for the deficit spending units toundertake more investment because it would enable them tocommand more capital. As Schumpeter has said, without thetransfer of purchasing power to an entrepreneur, he cannotbecome the entrepreneur. Further, it encourages investmentactivity by reducing the cost of finance and risk. This is done by

providing insurance services and hedging opportunities, and bymaking financial services such as remittance, discounting,acceptance and guarantees available. Finally, it not onlyencourages greater investment but also raises the level ofresource allocational efficiency among different investmentchannels. It helps to sort out and rank investment projects bysponsoring, encouraging, and selectively supporting businessunits or borrowers through more systematic and expert projectappraisal, feasibility studies, monitoring, and by generallykeeping a watch over the execution and management ofprojects.The contribution of a financial system to growth goes beyondincreasing prior-saving-based investment. There are two strandsof thought in this regard. According to the first one, asemphasized by Kalecki and Schumpeter, financial system plays apositive and catalytic role by creating and providing finance orcredit in anticipation of savings. This, to a certain extent,ensures the independence of investment from saving in a givenperiod of time. The investment financed through created creditgenerates the appropriate level of income. This in turn leads toan amount of savings, which is equal to the investment alreadyundertaken. The First Five Year Plan in India echoed this viewwhen it stated that judicious credit creation in production andavailability of genuine savings has also a part to play in theprocess of economic development. It is assumed here that theinvestment out of created credit results in prompt incomegeneration. Otherwise, there will be sustained inflation ratherthan sustained growth.The second strand of thought propounded by Keynes andTobin argues that investment, and not saving, is the constrainton growth, and that investment determines saving and not theother way round. The monetary expansion and the repressivepolicies result in a number of saving and growth promotingforces: (a) if resources are unemployed, they increase aggregatedemand, output, and saving; (b) if resources are fullyemployed, they generate inflation which lowers the real rate ofreturn on financial investments. This in turn, induces portfolioshifts in such a manner that wealth holders now invest more inreal, physical capital, thereby increasing output and saving; (c)inflation changes income distribution in favour of profitearners (who have a high propensity to save) rather than wageearners (who have a low propensity to save), and therebyincreases saving; and (d) inflation imposes tax on real moneybalances and thereby transfers resources to the government forfinancing investment.The extent of contribution of the financial sector to saving,investment, and growth is said to depend upon its being free orrepressed (regulated). One school of thought argues thatfinancial repression and the low/ negative real interest rateswhich go along with it encourage people (i) to hold their savingin unproductive real assets, (ii) to be rent -seekers because ofnon-market allocation of investible funds, (iii) to be indulgentwhich lowers the rate of saving, (iv) to misallocate resources andattain inefficient investment profile, and (v) to promote capital-intensive industrial structure inconsistent with thefactor-endowment of developing countries. Financialliberalisation or deregulation corrects these ill effects and leads to

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Nfinancial as well as economic development. However, asindicated earlier, some economists believe that financialrepression is beneficial. The most recent thinking on this subjectsays that the empirical foundations of financial liberalisation arenot robust enough, and that mild, moderate, small repressionis more growth promoting than either large-scale repression orcomplete laissez-faire.

Financial Sector and Economic Development: a

Cautionary ApproachMany economists have taken a cautionary view of the role offinancial markets in development. The capital marketenthusiasm and optimism implicit in certain theories offinance, viz., Capital Asset Pricing Model and Efficient MarketHypothesis with their multiple unrealistic, restrictiveassumptions, have been questioned in different ways.First, it has been argued that the financial sector can perform thedevelopmental role if it functions efficiently, but in practice, it isnot efficient. Tobins analysis in this respect is highly instructive.With logic and examples, he has explained how the prices infinancial markets rarely reflect intrinsic values; how very little ofthe work done by the securities industry has to do withfinancing real investment; how the allocation of funds byfinancial markets is hardly optimal; and that the services offinancial system do not come cheap. According to him, financialsystem serves us all right. But its functioning does not meritcomplacency. Financial activities generate high private rewarddisproportionate to their social productivity. The casino effectof financial markets cannot be forgotten. The speculation infinancial markets is a negative-sum game for the general public.More recently, through the application of chaos and fractalanalyses to financial markets, it has been shown that they arecharacterized by asymmetry, turbulence, discontinuity,stampedes, non-periodicity, and inefficiency.

Second, it has been pointed out that the roles of capitalformation and finance in development have been unduly ordisproportionately stressed; that capital shortage is not thesingle most important barrier to development. Empirically, ithas been very often found that the rate of capital formationincreased without raising the growth rate; and the relationbetween capital and growth has been one of correlation ratherthan causation. It is estimated that in industrialized countries,capital accumulation could account for at most one--fourth ofthe rate of economic growth in the 19th and 20th centuries.Increase in capital without suitable social, economic, politicalconditions cannot cause growth; and, on the other hand,favourable developments in the conditions just mentioned canachieve much growth with minimum of capital. Theconventional thinking has always stressed the need forsubstitution of capital for other factors but the scope andpossibilities for this kind of substitution, particularly in thelight of factor endowments, have never been really explored.For growth, much additional capital, and, therefore, muchfinance, is not always required; through depreciation allowances,better composition of capital, appropriate technology, andhigher productivity, a lot of growth can be achieved. Themethodology used for estimating the financial resourcerequirements (incremental capital-output ratio) is also riddledwith many valuations, measurement, and other problems.The thrust and message of the above analysis are clearlyexpressed in the following statements: Real growth cannot be bought with money alone (Chandler). By and large, it seems to be the case that where enterprise

leads, finance follows (Joan Robinson). Societies in whichother conditions of growth were favourable were usuallycapable of devising adequate financial institutions(Habakkuk).

The role of finance in development is a subsidiary one(Newlyn).

The Process of Financial DevelopmentHow does financial development occur? Is it influenced byeconomic development? Does the former always precede thelatter? The literature talks about supply leading and demandfollowing financial development. Under the former, financialdevelopment occurs first and stimulates economic growth.Under the latter, as trade, commerce and industry expand, thefinancial institutions, instruments, and services needed by themalso expand as a matter of response. The financial developmentis said to be active in the first case, and passive in thesecond one.Such a characterisation of the process of financial developmentis not very apt. It is difficult to establish precisely the sequenceof real and financial sector developments; the cause and effectrelationship between them is difficult to disentangle. It will bemore correct to say that their growths are intertwined,symbiotic, and mutually reinforcing. While financial marketsaccelerate development, they, in turn, grow with economicdevelopment. In the words of Schumpeter, the money marketis always the headquarters of the capitalist system, from whichorders go out to its individual divisions, and that which is

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debated and decided there is always in essence the settlement ofplans for further development. All kinds of credit requirementscome to this market; all kinds of economic project are firstbrought into relation with each other and contend for theirrealization in it; all kinds of purchasing power flows to it to besold. This gives rise to a number of arbitrage operations andintermediate manoeuvres, which may easily veil thefundamental thing. Thus, the main function of the money orcapital market is trading in credit for the purpose of financialdevelopment. Development creates and nourishes this market.In the course of development, it becomes the market forsources of income themselves.

Criteria To Evaluate Financial SectorAt the end of the discussion let us evaluate financial sectorcritically. Given the controversy regarding the contribution offinancial sector, it is necessary to have a framework to evaluatethe performance of the countrys financial sector. Let us firstlook at the criteria formulated, in the form of questions, byRichard D. Erb, the former Deputy Managing Director of theInternational Monetary Fund: (i) Do institutions find the mostproductive investments? (ii) Do institutions revalue their assetsand liabilities in response to changed circumstances? (iii) Doinvestors and financial institutions expect to be bailed out ofmistakes and at what price? (iv) Do institutions facilitate themanagement of risk by making available the means to insure,hedge, and diversify risks? (v) Do institutions effectivelymonitor the performance of their users, and discipline thosenot making proper and effective use of their resources? (vi)How effective is the legal, regulatory, supervisory, and judicialstructure? (vii) Do financial institutions publish consistent andtransparent information?These criteria, useful as they are, do not encompass social andethical aspects of finance, which ought to be regarded asimportant as economic aspects. Therefore, the relevantnormative criteria, organizing principles, and value premiseswhich should guide the functioning of the financial system are:(a) Finance is not the most critical factor in development. (b)The use of finance must be imbued with the virtues ofausterity, self--limit, and minimization. (c) Financial reforms arenot merely a question of credit limits; they encompass issuesinvolved in limits of credit. (d) State intervention is not thebest way to achieve a fair distribution of credit. (e) Financialinstitutions must evolve from below rather than be imposedfrom above. Financial development ought to take place at aslow and steady pace rather than in spurts and in a programmedor (time) encapsulated manner. (f) There should be areplacement of large-scale by small-scale, wholesale by retail, andclass by mass banking. (g) The sufficing principle rather than themaximising one should power the financial system. Thefunctioning of different financial institutions must be on thebasis of a communitarian spirit, not competition and profitmotive. (h) The financing of investment, which results in thedisplacement or retrenchment of labour, should bediscouraged. (i) The scope for financing various sectors isultimately constrained by domestic saving. The substantialincrease in the total saving in India is unlikely to take place now.(j) The working of the Indian financial system should not be

corporate-sector-centric. (k) There are limits to the overall andindustrial growth, and, therefore, a ceiling on the targeted rateof growth has to be imposed. (l) The only legitimate role ofthe financial markets is infrastructural, hence they should notexist to provide opportunities to make quick, disproportionatepecuniary gains. (m) It is the primary markets activity ofsupporting new, economically and socially productive realinvestment, trade, and flows of goods and services, which is offoremost importance. The enthusiasm, hyperactivity, andpreoccupation with the secondary markets ought to be avoided.

Questions to Discuss:1. What are the effects of Financial System on saving and

Investment?2. Discuss the relationship Between Financial System and

Economic Development?3. Discuss a cautionary approach on Financial Sector and

Economic Development?4. What are the criteria To Evaluate Financial Sector?

Notes:

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LESSON 4:FINANCIAL SYSTEM AND ECONOMIC DEVELOPMENT

Learning objectivesAfter reading this lesson, you will understand Financial development: some concepts Reforms model for economic growthToday we shall discuss some important concepts mostfrequently used in financial world..

Financial Development: Some ConceptsIn this section we discuss a few concepts, which describe thephenomenon of change and development in a financial system.All these concepts are closely inter-related, and at present they arewidely referred to in the discussions on financial markets.

EfficiencyWhat do you mean by efficiency? The ultimate focus of theefficiency in financial markets is on the nonwastefulness offactor use and the allocation of factors to the socially mostproductive purposes. The following five concepts are useful injudging the efficiency of a financial system.

Information Arbitrage EfficiencyThis is the degree of gain possible by the use of commonlyavailable information. If one can make large gains by usingcommonly available information, financial markets are said tobe inefficient. Thus, the efficiency is inversely related to this typeof gain. Under conditions of perfect market, the possibilities ofsuch a gain are nil because the prices in such a market alreadyreflect fully and immediately all relevant and ascertainableavailable information, and no one would know anything that isnot already known and therefore not reflected in market prices.

Fundamental Valuation EfficiencyWhen the market price of a security is equal to its intrinsic valueor investment value, the market is said to be efficient. Theintrinsic value of an asset is the present value of the futurestream of cash flows associated with the investment in thatasset, when the cash flows are discounted at an appropriate rateof discount. This again would happen when markets areperfectly competitive.

Full Insurance EfficiencyThis indicates the extent of hedging against possible futurecontingencies. The greater the possibilities of hedging andreducing risk, the higher the market efficiency.

Functional or Operational EfficiencyThe market which minimizes administrative and transactioncosts, and which provides maximum convenience (or minimuminconvenience) to borrowers and lenders while performing thefunction of transmission of resources, and yet provides a fairreturn to financial intermediaries for their services, is said to beoperationally or functionally efficient.

Allocational EfficiencyWhen financial markets channelise resources into thoseinvestment projects and other uses where marginal efficiency ofcapital adjusted for risk differences is the highest, they are said tohave achieved allocational efficiency.

InnovationsFinancial innovation can be variously defined as theintroduction of a new financial instrument or service or practice,or introducing new uses for funds, or finding out new sourcesof funds, or introducing new processes or techniques to handleday-to-day operations, or establishing a new organisation-allthese changes being on the part of existing financialinstitutions. In addition, the emergence and spectacular growthof new financial institutions and markets is also a part offinancial innovation. The word new here means not only thecoming into being of what did not exist till then but also thenew way of using existing instruments, practices, technology,and so on. Similarly, the use or adoption of an already existingfinancial instrument, by financial institution(s), whichpreviously did not do, so is also regarded as an innovation. Themarked transformation in the roles of financial institutions andthe departure from the conventional notions regarding theirfunctions also constitute financial innovation. As per onedefinition, financial innovations are unforecastableimprovements in the array of available financial products andprocesses.Financial innovations bring about wide ranging changes as wellas effects in the financial system. They lead to the broadening,deepening, diversification, structural transformation,internationalization and sophistication of the financial system.They result in the financialisation of the economy wherebyfinancial assets to total assets ratio tends to increase. Thisfinancialisation may occur with the growth ofinstitutionalisation or intermediation and securitisationsimultaneously, or it may occur with the growth of one at thecost of other.The process of financial innovation has been characteriseddifferently by different authors. These innovations are regardedas responses to regulatory and tax regimes, financial constraints,and so on. The literature on the subject suggests the followinggroups of factors as being responsible for financial innovations:(i) tax asymmetries that can be exploited to produce tax savings;(ii) transaction costs; (iii) agency costs; (iv) opportunities toreduce or reallocate risk; (v) opportunities to increase asset-liquidity; (vi) regulatory or legislative change; (vii) level andvolatility of interest rates and prices; and (viii) technologicaladvances.

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Financial EngineeringThis is perhaps the latest terminological addition to the worldof finance, which, incidentally, is a new example of the invasionof social thinking by technology. After innovations, industrialengineering and social engineering, we now have financialengineering. It basically means financial innovations; the twoterms have often been used interchangeably. The dictionarymeanings of innovation and engineering perhaps give a clue tothe possible difference between financial innovations andfinancial engineering. To innovate means to introduce newmethods, new ideas, and make changes. To engineer means toarrange, contrive, to bring about artfully or skilfully.Financial engineering thus connotes development of newfinancial technology to cope with financial changes. It involvesconstruction, designing, deconstruction, and implementationof innovative financial institutions, processes, and instruments.It means the formulation of creative solutions to problems infinance. The development and use of skills, means, techniques,tools for changing and managing cash flows and investmentfeatures of financial instruments form a part of financialengineering. In todays highly volatile markets, it seeks to limitfinancial risk by creating financial instruments for hedging,speculation, arbitraging, and by fine-tuning portfolioadjustments. It also seeks to maximise profits quickly. Thecreation of financial derivatives and securitisation are its twoexamples. Computer power and human insight are combinedto spot arbitrage opportunities, measure risk, and to react tonews very fast in financial engineering.

Financial RevolutionSome people believe that a veritable financial revolution hastaken place in the world of finance in the recent past. Theconcept of financial revolution is an extension of the conceptsof financial innovations and engineering. It is meant to conveythat, of late, the magnitude, speed, and spread of changes inthe financial sector the world over has been simply tremendous,prodigious, phenomenal; that it has undergone a futureshock. It indicates that life in the world of finance is no longereasy and that financial markets now work 24 hours a day. Theinnovations in computers and satellite communications, andthe linking up of the two have completely changed theproduction, marketing, and delivery of financial products. Andas with every revolution, not all changes have been for the best,and there have been unexpected consequences.

DiversificationIn one sense, diversification means the existence or thedevelopment of a very wide variety of financial institutions,markets, instruments, services, and practices in the financialsystem. In another but related sense, it refers to the presence ofopportunities for investors to purchase a large mix or portfolioof varieties of financial instruments. With the diversifiedportfolio, investors can minimise the risk for a given rate ofreturn, or they can maximise the return for a given risk.

DisintermediationIt refers to the phenomenon of decline in the share of financialintermediaries in the aggregate financial assets in an economybecause people switch out of their liabilities into directsecurities in the open market. Such a flow of funds out of these

intermediaries may occur when they are subject to interest rateceilings while the open market rates of return are rising.The terms securitisation and disintermediation are often usedinterchangeably. Although these terms are very closely related,one should be careful in using them interchangeably. A declinein the share of only a particular type of financial intermediary,say commercial banks, does not necessarily meandisintermediation. Similarly, securitisation in the second sensedoes not involve disintermediation.

Broad, Wide, Deep and Shallow MarketsAll these are closely related terms. The broad and wide financialmarket attracts funds in greater volume and from all types ofnational and international investors. In such a market, financialinstitutions offer, even globally, 24-hour sales and tradingcapability in debt and equity instruments. The deep market isone where there are always sufficient orders for buying andselling at fine quotations both below and above the marketprice, and where there are good opportunities for swap deals. Aswap deal is a medium-term or long-term arrangement betweentwo parties in which each party commits to service the debt ofthe other. In other words, a swap is the exchange of futurestreams of payment between two or more parties. The shallowmarket, on the other hand, means an underdeveloped market,its underdevelopment being the result of financial repressionor administered finance.

Financial RepressionIt represents economic conditions in which the governmentsregulatory and discretionary policies distort financial prices orinterest rates (i.e., the real interest rates are kept low or negative),discourage saving, reduce investment, and misallocate financialresources. The government-directed credit program, and directrather than indirect credit controls predominate in a repressedsystem. As indicated above, it is also known as the system ofadministered interest rates and finance.

Financial Reforms, Financial Liberalisation, and

DeregulationFinancial reforms involve instituting policies, which will increasethe allocative efficiency of available saving, promote the growthof real sector, and enhance the health, stability, profitability, andviability of the financial institutions. In theory, they need notnecessarily increase the market -orientation of the system, but inpractice at present, they have come to mean greater marketorientation. Therefore, liberalisation, deregulation, and reformsmean the same thing currently. They refer to the policy ofreducing or removing completely the legal restrictions, physicalor administrative or direct controls, ceilings on interest rates,restrictions on the flow of funds, official directives regardingsectoral and other allocations of funds, restrictions on the scopeof activities of banks and other financial institutions, and soon, which exist under the administered finance. It is obviousthat liberalisation is the process in which the intervention orinterference of the government in financial markets is reducedand the markets are allowed, as far as possible, to function onthe basis of free market or competitive principles.

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NPrivatisationIt is regarded as a necessary part of financial reforms. It meansincreasing the ownership, management, and control of thefinancial sector by individuals and private incorporated andunincorporated bodies. This may be achieved partly bydenationalisation, disinvestments by the state, allowing privatesector entry, and abstaining from new ownership by the state.

Prudential RegulationThis is another major element of financial sector reforms. Itmeans regulation without suppression, and supervision andcontrol without constriction. It implies that the authorities havenot abdicated the role of and responsibility for evolving ahealthy, strong, sound, safe, stable, and viable financial system.It aims to impart greater transparency and accountability inoperation, and to restore credibility and confidence in thefinancial system. It relates to income recognition, assetsclassification, provisioning for bad and doubtful debts, andcapital adequacy. The prudential regulation is the policy of theState with regard to macro and micro prudential concerns.

1ntegrationIt refers to the establishment of close connections or effectivelinkages between different constituents or parts, and betweendifferent sub-parts of the financial system. As a result, there aresubstantial flows of funds between them, and there is a greatercorrespondence between interest rates in different parts of thefinancial system. Financial integration is the opposite of thematuritywise, geographical, institutional, seasonal, instrumental,segmentation or partitioning or compartmentalisation of thefinancial markets.

Internationalisation and GlobalisationThese terms indicate the extension of activities of a financialsystem beyond the national boundaries. The extension maytake place in the form of borrowing as well as lending, and itmay take place through official or private or commercial channel.In the process of internationalisation, the domestic financialinstitutions participate in foreign financial markets, and theforeign institutions participate in domestic markets to asignificant extent. In other words, the domestic and foreignfinancial markets get integrated and interlinked, and the supplyand demand curves of funds assume a different character.When globalisation occurs, financial instruments may bedenominated in several currencies, and there would be aconvergence of interest rates in different national markets,because interest rate changes originating in one financial centrewould be quickly transmitted to other centres.Sometimes, a distinction is made between internationalisationand globalisation. While the former term is used to indicate theabsence of regulation or control of any national authority onfinancial markets, the latter is said to refer to the establishmentof interlinkages among national markets as a result of theprogressive liberalisation and the removal of exchange controls.This distinction is not really convincing; it is based on theideology-induced narrowing down of the meaning of the terminternationalisation.

SecuritisationThe term securitisation is used in financial literature in twosenses. First, it means the faster growth of direct (primary)financial markets and financial instruments than that offinancial intermediaries. In other words, it refers to the growingability and practice of firms to tap the bond, commercial paper,and share markets as alternatives to institutional financing.Second, it refers to the process by which the existing assets ofthe lending financial institutions are sold or removed fromtheir balance sheets through their funding by other investors. Inthis process, investors are sold securities, which evidence theirinterest in the underlying assets without recourse to the originallender. The redemption of these securities does not become theobligation of the original lender. The payments to the investorsare made to the extent of cash flows realised from theunderlying assets. What happens is that a number of assets ofa given lender having similar characteristics are pooled together,and undivided interests in this pool are sold in the form ofwhat are called Pass Through Certificates (PTC). The tenor(maturity) of the PTC generally matches the average maturity ofthe pooled assets. The cash flows from the underlying assets arepassed through, after retaining management fees, to the holdersof PTC in the form of periodic (monthly) payments of interestand principal. The redemption of securities is made only to theextend of the cash flows realised from the underlying assets.The securitisation essentially involves the collateralisedfinancing rather than the sale of assets. The ever-increasingresource requirements and the desire to maintain high levels ofdisbursements while keeping the overall size of assets withincertain limits have led financial institutions to innovate in theform of securitisation. The deal between ICICI and Citibank tosecuritise ICICIs Sellers Line of Credit Bills of Exchange, hadmarked the first securitisation deal in India.

Indian Financial Markets and Banking System-

Reforms Model for Economic GrowthCross-country evidence suggests that economic growth ispositively related to financial development. Recent economicresearch studies by leading global investment bankers indicatethat, over the next few decades, the growth generated by thelarge developing countries, particularly the BRICs (Brazil,Russia, India and China) could become a much larger force inthe world economy than it is now. For India, the multi-dimensional reforms model adopted for our financial sector adecade ago is now bringing in a robust picture of the financialsystem and our economy.The pre-reforms phase of pre-emption of resources and micro-management by Government, interest rate regulation, a licenceRaj and a closed economy gave way to a unique reforms modelwith multiple dimensions for all-round development of thefinancial sector. The financial sector reforms followed thetraditional pancha sutra approach of cautious and propersequencing; mutually reinforcing measures; complementaritybetween reforms in the banking sector and changes in fiscal,external and monetary policies; developing financialinfrastructure; and developing financial markets.The reforms have covered key segments of the Indian financialmarkets: capital markets, the money and Government securities

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markets and the forex markets. With prudential strengtheningof the banking system coupled with real sector reforms, therehas been a gradual transformation of the Indian economy.The capital markets have demonstrated improved marketefficiency and transparency. The institutionalisation of SEBI,the incorporation of NSE, the enactment of Depositories Act,screen-based trading, entry of FIIs and mutual funds, access tointernational capital markets through ADRs, GDRs, FCCBs etc.have all contributed to this transformation. Inspite of theMonday mayhem on our bourses following the election results,the following weeks figures indicated that there were netinflows through the FII route. Our systems for managingmarket volatility in the Stock Exchanges also clicked into place aswas evident with the circuit breakers for sudden marketswings getting into operation.The money markets have now gradually become a conduit forproviding an equilibrating mechanism for evening out short-term surpluses and deficits in the financial system. Measures arebeing taken to have a pure inter- bank call/ notice moneymarket. Collateralised borrowing and lending obligation(CBLO) has been operationalised as a money marketinstrument through the Clearing Corporation of India Ltd.(CCIL).The G-sec market has seen significant liquidity and depth post-1990. The initial reforms of moving to an auction based systemfor issuing Government debt, terminating the system ofautomatic monetisation of fiscal deficit were complementary tointerest rate deregulation in the banking sector. Primary Dealerswere institutionalized. FIIs were allowed to invest in G-securities and T-bills in primary and secondary markets subjectto certain ceilings. Other measures included issuance of uniformaccounting norms for repo and reverse repo transactions, facilityfor anonymous screen-based order-driven trading system for G-secs on stock exchanges, introduction of exchange-tradedinterest rate derivatives on the National Stock Exchange (NSE),relaxation in regulation relating to sale of securities bypermitting sale against an existing purchase contract, facilitatingthe roll over of repos and switch over to the DVP III mode ofsettlement. Market Stabilisation Scheme (MSS) has beenintroduced to differentiate the liquidity absorption of a moreenduring nature by way of sterilisation from the day-to-daynormal liquidity management operations.Our Forex policies are in line with global best practices. Forexreserves of over $118 billion are now a buffer for crisisprevention, providing confidence to the markets and protectionagainst exchange rate volatility. Substantial delegation of powersto the banking system in the area of international trade,remittances, borrowings and investments has helped bringabout greater openness and reassured the global market playersof our inherent strengths.The impact of reforms on the banking industry has beensubstantial. There has been an increase in operational efficiencyand profitability. NPA levels are coming down. There is greateruse of technology for transaction processing and informationmanagement using computer and communication devices. Ourbanks have now a greater awareness of credit risk management.Further progress on this front would have to be taken up by

developing unique credit risk models for risk-rating and pricingand real-time credit monitoring. The risk managementframework for market risk using internal models is beingdeveloped by Indian banks. Use of derivatives for market riskmanagement is on the increase. Banks are now moving towardsthe Basel II framework for capital allocation and riskmanagement. Banks are actively considering measures to containimpact of operational risks to manageable limits.The challenges for the banks in the times to come would be tocounter increased competition, meeting the demandingstandards of customers, stepping up of income and to movetowards becoming one-stop financial hyper-markets. The keyfor this would be in technological advances, going in for risk-bundling and rebundling through new financial products,sound risk management architecture and enhancing share-holder value.Our reforms model would dynamically incorporate measuresfor risk management, adequate capital allocation, soundregulatory and supervisory practices. These would providenecessary conditions for a long-term growth path towards ourcountry becoming one of the largest economies.

SummaryThe ultimate goal of the financial system is to accelerate the rateof economic development. While financial markets mayaccelerate development, they themselves, in turn, develop witheconomic development. The relationship between economicdevelopment and financial development is thus symbiotic.Efficient financial markets are characterised by the absence ofinformation-based gain, by correct evaluation of assets, bymaximisation of convenience and minimisation of transactionscosts, and by maximisation of marginal efficiency of capital. Inreality, the contribution of the financial system to growth ishighly constrained because it does not work efficiently andcapital is not the most important barrier to growth. The role offinance in development is believed to be secondary by manyexperts. A framework to evaluate the working of any financialsector must include economic, commercial as well as social andethical criteria. Financial innovations refer to wide-rangingchanges in the financial system. The introduction of newfinancial institutions, markets, instruments, services,technology, organisation, and so on are parts of financialinnovations. Financial engineering connotes skilfuldevelopment and use of new financial technology, creativesolutions, and tools to cope with financial changes. It involvesconstruction, designing, deconstruction of innovative financialinstruments, institutions and processes to reduce risk and tomaximise profits quickly. Financial revolution means that themagnitude, speed, and spread of changes in the financial sectorare simply phenomenal. The markets, which attract funds inlarge volume and from all types of investors, are known asbroad financial markets. The markets, which provideopportunities for sufficient orders at fine rates below and abovethe market price, are called deep financial markets. Markets thatare underdeveloped due to governmental regulations andcontrols are termed as shallow financial markets. Financialrepression exists when the regulatory policies of thegovernment distort interest rates, discourage saving, reduce

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Ninvestment, and misallocate resources. Financial reforms orliberalisation aim at creating a market-oriented, competitivefinancial system by removing physical, administrative, and directcontrols. Financial integration refers to the establishment ofclose and effective interlinkages between various parts and sub-parts of the financial system so that interest rates differentials inthe system are minimised. Securitisation refers to a fast growthof direct (primary) financial instruments, and to a collateralizedfinancing through the sale of existing assets of financialinstitutions. Disintermediation refers to the switch out of theliabilities of financial intermediaries by the investors.Internationalisation or globalisation of financial markets occurswhen national and foreign markets become integrated.

Questions to Discuss:1. What do you mean by efficiency? Discuss five concepts are

useful in judging the efficiency of a financial system.2. What do you understand by innovations, privatization and

securitisation?3. Discuss the Indian Financial Markets & Banking System-

Reforms Model for Economic Growth.

Notes:

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LESSON 5:THE INDIAN FINANCIAL SYSTEM ON THE EVE OF PLANNING

Learning ObjectiveAfter reading this lesson, you will understand Evaluation of various constituents of Indian Financial

system prior to 1950. Evaluation of currency and money supplyThe Indian financial system has covered a long journey. It hasand always will hold an important position in our economy. Letus understand how?

Currency and Money SupplyCurrency and exchange form an essential part of any financialsystem. Prior to Independence, the Indian currency had notbeen standardised. For about 60 years till 1893, it had remainedon the silver standard and subsequently on the gold exchangestandard. During this period (with the exception of the waryears), even though gold could be procured through importwithout any restrictions, the system did not fulfill the otheressential requirements of the gold standard. First, gold coinswere not very much in circulation. Second, the currency authoritydid not accept the responsibility of selling gold without limit. Ithad acquired legally the option of offering gold or sterlingagainst rupees. As sterling was on the gold standard, the rupeecan be said to have been on the gold exchange standard. Withthe abandonment of the gold standard by England inSeptember 1931, the sterling exchange standard came to beestablished in India.Paper currency has been used in India since the beginning of the19th century. Currency notes were issued by the commercialbanks and their use was extremely limited. In 1861, thegovernment acquired the monopoly of issuing notes. An ideaof the progress of monetisation can be obtained from thevolume of notes issued and their circulation. While the volumeincreased from Rs 11 crore in 1874 to Rs 1199 crore in 1948, thecirculation increased from Rs 10 crore to Rs 1188 crore duringthe same period. If we take the total money supply (currencyand demand deposits), it increased from Rs 285 crore in 1935and to Rs 384 crore in 1939, and to Rs 2052 crore in 1945.Thereafter, it declined to Rs 1970 crore in 1948, and to Rs 1833crore in 1950.3 Thus the major increase in the volume ofmoney in India occurred during the Second World War.Currency constituted a major portion of the money supply. Thepercentage of currency to total money supply increased from57.22 per cent in 1935 to 65.61 per cent in 1950 and 66.68 percent in 1952.

Banking SectorThe two most important constituents of the money market inIndia are the modern banks and the indigenous bankers.Modern banking became an effective force only after 1910.Before that the indigenous bankers dominated the scene. Until1860, they financed trade,

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