IFS Unit 1 Indian Financial System | Bangalore university/Calcutta university
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UNIT 1:
INTRODUCTION TO FINANCIAL SYSTEM IN INDIA
Overview of financial system
A financial system is a matrix of financial institutions, financial markets , financial instruments, and financial services which allows the exchange of funds between borrowers lenders and investors . In order to enable capital formation there is a requirement of a system which will create and channelise savings leading to capital formation.The system that does this function in economy is called financial system.
Financial System helps to mobilize the surplus funds and utilizing it in a productive manner
The Indian Financial System is one of the most important aspects of the economic development of our country. It enables investors, lenders and borrowers to exchange funds either for productive or consumptive purpose and to pursue a return on their financial assets.
Thus, a financial system can be said to play a significant role in the economic growth of a country by mobilising the surplus funds and utilising them effectively for productive purposes.
Structure of Indian Financial System/Components of Financial System
1. Financial Institutions
2. Financial Markets
3. Financial Intermediaries
4. Financial Services
Features of Indian Financial system:
- It plays a vital role in the economic development of the country as it encourages both savings and investment
- It helps in mobilising and allocating one’s savings
- It helps in allocation of risk
- It facilitates the expansion of financial institutions and markets
- Plays a key role in capital formation
- It creates a link between the investor and the money savers
- It is also concerned with the provision of funds
IFS unit 2-Banking institutions notes
Regulations of financial system
The main objective of all regulators is to maintain fairness and competition in the market and provide the necessary regulations and infrastructure.Strict actions are taken against any misconduct and thus the regulators of financial system ensures that the interests of investors and consumers are protected. The regulators are listed below
- To regulate the issue of bank notes and keeping of reserves for securing monetary stability
- Operate currency and credit system of the country to its advantage
- To have a modern monetary policy framework to meet the challenges of an increasingly complex economy
- To maintain price stability while keeping in mind the objectives of growth
- Provides credit for agricultural and rural activities
- All the rural government schemes(like PMAY-G, SBM-G, LTIF)funding are provided by NABARD
- The basic purpose of SEBI is to create an environment to facilitate efficient mobilisation and allocation of resources through the securities markets.
- To regulate stock exchanges and the securities industry to promote their orderly functioning.
- To protect the rights and interests of investors, and to guide and educate them.
- To prevent trading malpractices
- To regulate and develop a code of conduct and fair practices by intermediaries like brokers, merchant bankers etc.
- The IRDA regulates the insurance industry and protects the interests of insurance policyholders and has strict control over insurance rates, beyond which no insurer can go.
- The IRDA specifies the qualifications and training required for insurance agents and other intermediaries, which then have to be followed by the insurer.
- It can levy fees and modify them as well, as per the IRDA Act. It regulates and controls premium rates and terms and conditions that insurers are allowed to provide.
- Any benefit provided by an insurer has to be ratified by the IRDA.
- The PFRDA is a sole regulator of India’s pension sector. Its services extend to all citizens, including non-resident Indians (NRIs).
- Its main objective is to ensure income security for senior citizen and regulates pension funds and protects pension scheme subscribers.
- PFRDA regulates the pension schemes: NPS and Atal Pension Yojana. PFRDA Act is applicable on these schemes.
1.Savings function
Public savings find their way into the hands of those in production through the financial system. Financial claims are issued in the money and capital markets which promise future income flows. The funds with the producers result in production of goods and services thereby increasing society living standards.
2.Liquidity function
The term liquidity refers to ready cash and other financial assets which can be converted into cash without loss of value and time. It provides liquidity in the market through which claims against money can be resold by the investors and thereby assets can be converted into cash anytime.
3. Payment function
A financial system inspires the operators to monitor the performance of the investment. It provides a payment mechanism for the exchange of goods and services and transfers economic resources through time and across geographic regions and industries.
4. Risk function
The term risk and uncertainty can be defined as the probability of happening of an unexpected event due to which the investors may be under loss in future. Whenever the mobilised savings are invested into different productive activities, the investors are expected to lower risk. This is because of the benefits of ‘diversification’ that is available to even small investors.
5. Policy function
The government intervenes in the financial system to influence macro-economic variables like interest rates or inflation. So if country needs more money government would cut rate of interest through various financial instruments and if inflation is high and too much money is available in the system, then government would increase the rate of interest.
6. Provides financial services
A financial system minimizes situations where one party has the information and the other party does not. It provides financial services such as insurance, pension etc. and offers portfolio adjustment facilities.
7. Lowers the cost of transactions
A financial system helps in the creation of a financial structure that lowers the cost of transactions. This has a beneficial influence on the rate of returns to saver. It also reduces the cost of borrowings. Thus, the system generates an impulse among the people to save more.
8. Financial deepening and broadcasting
A well-functioning financial system helps in promoting the process of financial deepening and broadening. Financial deepening refers to an increase of financial assets as a percentage of the Gross Domestic Product(GDP). Financial broadening refers to building an increasing number variety of different participants and instruments.
COMPONENTS/ CONSTITUENTS OF INDIAN FINANCIAL SYSTEM
The following are the four major components that comprise the Indian Financial System:
1. Financial Institutions
2. Financial Markets
4. Financial Instruments
1.Financial Institutions
Financial institutions act as the intermediaries who facilitate smooth functioning of the financial system by making investors and borrowers meet and accept deposits from savers or investors and lend these funds to another set of customers or borrowers . Similarly investing institutions also accumulate savings and lend these to borrowers, thus perform the role of financial intermediaries. They mobilise savings of the surplus units and allocate them in productive activities promising a better rate of return.
Financial institutions can be classified into two categories:
A. Banking Institutions
B. Non - Banking Financial Institutions
a. BANKING INSTITUTIONS (Reserve Bank of India)
Indian banking industry is subject to the control of the Central Bank. The RBI as the apex institution organises, runs, supervises, regulates and develops the monetary system and the financial system of the country.
The Indian banking institutions can be broadly classified into two categories as organised sector and unorganised sector
The organised banking sector consists of commercial banks, cooperative banks and the regional rural banks.
(a)Commercial Banks: The commercial banks may be scheduled banks or non – scheduled banks. At present only one bank is a non - scheduled hank. All other banks are schedule banks.
(b) Co-operative banks: They are an important segment of the organised sector and is represented by a group of societies registered under the Acts of the states relating to cooperative societies. Different types of co-operative credit societies are operating in Indian economy.
These institutions can be classified into two broad categories: (a) Rural credit societies which are primary meant for agriculture, (b) Urban credit societies which are primarily for non-agriculture.
(c) Regional Rural Banks (RRBs): Regional Rural Banks were set by the state government with the objective of developing the rural economy. They provide banking services and credit to small farmers and small entrepreneurs in the rural areas. They were set up with a view to provide credit facilities to weaker sections.
(d) Foreign Banks: Foreign banks have been in India from British days. Foreign banks are banks that have branches in the other countries and main Head Quarter in the Home Country.
In the unorganised banking sector are the Indigenous Bankers who are private firms or individuals who operate as banks and as such both receive deposits and given loans and Money Lenders who depend entirely on their own funds and whose operations are entirely unregulated and charge very high rate of interest on loans given by them.
b.Non – Banking Institutions
The non – banking institutions may be categorised broadly into two groups:
(a)Organised Non – Banking Financial Institutions. -these include development Finance Institutions like Industrial Finance Corporation of India , Industrial Credit and Investment Corporation of India , Industrial Development Bank of India at all India level and the State Finance Corporations (SFCs),State Industrial Development Corporations (SIDCs) at the state level. Agriculture Development Finance Institutions such as NABARD, LDBS etc.also comes under this. and Investment Institutions like LIC, GIC, LTT, and mutual funds.
(b) Unorganised Non – Banking Financial Institutions. -include number of non - banking financial companies (NBFCs) providing whole range of financial services. These include hire-purchase consumer finance companies, leasing companies, housing finance companies, factoring companies, Credit rating agencies, merchant banking companies etc.
2.Financial Markets
A financial market helps to link the savers and the investors by mobilising funds between them. It allocates or directs funds available for investment into their most productive investment opportunity.The marketplace where buyers and sellers interact with each other and participate in the trading of money, bonds, shares and other assets is called a financial market.
The financial market can be further divided into
A financial market helps to link the savers and the investors by mobilising funds between them. It allocates or directs funds available for investment into their most productive investment opportunity.The marketplace where buyers and sellers interact with each other and participate in the trading of money, bonds, shares and other assets is called a financial market.
The financial market can be further divided into
a.Money Market
The money market is a market for short term funds which deals in monetary assets whose period of maturity is up to one year. It is a market where low risk, unsecured and short term debt instruments that are highly liquid are issued and actively traded everyday. It has no physical location, but is an activity conducted over the telephone and through the internet. It enables the raising of short-term funds for meeting the temporary shortages of cash and obligations and the temporary deployment of excess funds for earning returns.
The major participants in the market are the Reserve Bank of India (RBI), Commercial Banks, Non-Banking Finance Companies, State Governments, Large Corporate Houses and Mutual Funds.
a.Money Market
The money market may be subdivided into four. They are:
(i) Call money market
It is a market for extremely short period loans say one day to fourteen days. So, it is highly liquid. In India, call money markets are associated with the presence of stock exchanges and hence, they are located in major industrial towns like Bombay, Calcutta, Madras, Delhi, Ahmadabad etc. The special feature of this market is that the interest rate varies from day to day and even from hour to hour and Centre to Centre. It is very sensitive to changes in demand and supply of call loans.
(ii) Commercial bills market
It is a market for Bills of Exchange arising out of genuine trade transactions. In the case of credit sale, the seller may draw a bill of exchange on the buyer. The buyer accepts such a bill promising to pay at a later date specified in the bill. The seller need not wait until the due date of the bill. Instead, he can get immediate payment by discounting the bill.
(iii) Treasury bills market It is a market for treasury bills which have ' short - term ' maturity. A treasury bill is a promissory note or a finance bill issued by the Government.It is highly liquid because its repayment is guaranteed by the Government. It is an important instrument for short term borrowing of the Government
There are two types of treasury bills namely (i) ordinary or regular and (ii) ad hoc treasury bills popularly known as ' ad hocs’. Ordinary treasury bills are issued to the public, banks and other financial institutions with a view to raising resources for the Central Government to meet its short term financial needs. Ad hoc treasury bills are issued in favour of the RBI only. They are not sold through tender or auction. They can be purchased by the RBI only.
(iv) Short term loan market. It is a market where short - term loans are given to corporate customers for meeting their working capital requirements. Commercial banks play a significant role in this market and provide short term loans in the form of cash credit and overdraft Over draft facility is mainly given to business people whereas cash credit is given to industrialists.
b.Capital Market
The term capital market refers to facilities and institutional arrangements through which long-term funds, both debt and equity are raised and invested. It consists of a series of channels through which savings of the community are made available for industrial and commercial enterprises and for the public in general. It directs these savings into their most productive use leading to growth and development of the economy.
The capital market consists of development banks, commercial banks and stock exchanges. An ideal capital market is one where finance is available at reasonable cost.
The capital market can further be divided into
(i) Primary market or New issue market
Primary market is a market for new issues or new financial claims. Hence, it is also called New Issue market. The primary market deals with those securities which are issued to the public for the first time. In the primary market, borrowers exchange new financial securities for long term funds. Thus, primary market facilitates capital formation.
(ii) Secondary market or Stock exchange
Secondary market is a market for secondary sale of securities. Securities which have already passed through the new issue market are traded in this market. This market consists of all stock exchanges recognised by the Government of India. The stock exchanges in India are regulated under the Securities Contracts (Regulation) Act 1956.
3.Financial Services
Efficiency of a financial system depends upon the quality and variety of financial services provided by financial intermediaries. The term financial services can be defined as “activities, benefits, and satisfactions, connected with the sale of money, that offer to users and customers, financial related value. within the financial services industry.The main sectors are banks, financial institutions, and non-banking financial companies.
Financial services can be broadly classified into two categories.
a.. Asset based/fund based services.
b.. Fee based/advisory services.
a.Asset based/fund based services
1. Equipment Leasing/ Lease Financing
Leasing is a arrangement that provides a firm with the use and control over assets without buying and owning the same. It is a form of renting assets. However, in making an investment, the firm need not own the asset. It is basically interested in acquiring the use of the asset. Thus, the firm may consider leasing of the asset rather than buying it.
2. Hire Purchase and Consumer Credit
Hire purchase means a transaction where goods are purchased and sold on the terms that (i) payment will be made in instalments, (ii) the possession of the goods is given to the buyer immediately, (iii) the property ownership) in the goods remains with the vendor till the last instalment is paid,(iv) the seller can repossess the goods in case of default in payment of any instalment, and (v) each instalment is treated as hire charges till the last instalment is paid.
3.Venture Capital
venture capital companies provide the necessary risk capital to the entrepreneurs so as to meet the promoters contribution as required by the financial institutions.
4. Insurance Services Insurance is a contract where by the insurer e. insurance company agrees/ undertakes, in consideration of a sum of money (premium) to make good the loss suffered by the insured (policy holder) against a specified risk.The property which is insured is the subject matter of insurance.
5. Factoring Factoring, as a fund based financial service provides resources to finance receivables as well as it facilitates the collection of receivables. It is another method of raising short - term finance through account receivable credit offered by commercial banks and factors.
B. FEE BASED ADVISORY SERVICES
(i) Merchant Banking Fee based advisory services includes all these financial services rendered by Merchant Bankers. The Industrial Credit and Investment Corporation of India (ICICI) was the first development finance institution to initiate such service in 1974. Financial Services provided by these organisations include loan syndication portfolio management, corporate counselling project counselling debenture trusteeship, mergers acquisitions.
(ii) Credit Rating Credit rating is the opinion of the rating agency on the relative ability and willingness of the issuer of debt instrument to meet the debt service obligations as and when they arise. As a fee based financial advisory service, credit rating useful to investors, corporates (borrowers), banks and financial institutions. For the investors, it is an indicator expressing the underlying credit quality of a (debt) issue programme.
(iii) Stock - Broking Prior to the setting up of SEBI, stock exchanges were being supervised by the Ministry of Finance under the Securities Contracts Regulation Act (SCRA) and were operating more or less self-regulatory organisations.
4.Financial Instruments
(i) Primary market or New issue market
Primary market is a market for new issues or new financial claims. Hence, it is also called New Issue market. The primary market deals with those securities which are issued to the public for the first time. In the primary market, borrowers exchange new financial securities for long term funds. Thus, primary market facilitates capital formation.
(ii) Secondary market or Stock exchange
Secondary market is a market for secondary sale of securities. Securities which have already passed through the new issue market are traded in this market. This market consists of all stock exchanges recognised by the Government of India. The stock exchanges in India are regulated under the Securities Contracts (Regulation) Act 1956.
Financial instruments are assets that can be traded.Most types of financial instruments provide efficient flow and transfer of capital all throughout the world's investors. These assets can be cash, a contractual right to deliver or receive cash or another type of financial instrument, or evidence of one's ownership of an entity.
Types of Financial Instruments
Financial instruments may be divided into three types: Cash instruments, Derivative instruments and Foreign Exchange Instruments.
1. Cash Instruments: The values of cash instruments are directly influenced and determined by the markets. These can be securities that are easily transferable. Within cash instruments there are two types:
Securities: Securities are negotiable financial instruments issued by a company or government that give ownership rights, debt rights, or rights to buy, sell, or trade an option
Deposits and Loans: Deposit is a feature provided by the bank for the benefit of the customer investing the money for security and interest income benefits, whereas, the loan is a feature provided by the bank to the customers who need financial assistance.
2. Derivative Instruments: A derivative is an instrument whose value is derived from the value of one or more underlying, which can be commodities, precious metals, currency, bonds, stocks, stocks indices, etc. Four most common examples of derivative instruments are Forwards, Futures, Options and Swaps.
Interlink between capital market and money market
1. Lenders may choose to direct their funds to either or both markets depending on the availability of funds, the rates of return, and their investment policies.
2. Borrowers may obtain their funds from either or both markets according to their requirements. A firm may borrow short-term funds by selling commercial paper or it may float additional shares or bonds.
3. Some corporations and financial institutions serve both markets by buying and selling short-term and long-term securities.4. All long-term securities become short-term instruments at the time of maturity. So some capital market instruments also become money market instruments.
5. Funds flow back and forth between the two market s whenever the treasury finances maturing bills with treasury securities or whenever a bank lends the proceeds of a maturing loan to a firm on a short-term basis.
6. Yields in the money market are related to those of the capital market. A fall in the short-term interest rates in the money market shows a condition of essay credit which is likely to be followed or accompanied by a more moderate fall in the long-term interest rates in the capital market. However, money market interest rates are more sensitive than are long-term interest rates in the capital market.
Characteristics of financial market
The major macroeconomic indicators are also very important pieces of data for the outlook of the financial services sector.Financial services companies rely on high levels of business activity to generate revenue because they act as the intermediary in many economic transactions.Economic indicators are released through studies, surveys, sector reports, and the data-gathering efforts of government agencies.
1. Interest Rates
Interest rates are the most significant indicators for banks and other lenders. Banks profit from the difference between the rates they pay depositors and the rates that they charge to borrowers. Banks find it increasingly difficult to pass on interest rate costs to consumers as rates rise. High borrowing costs correspond with fewer loans and more saving. This limits the volume of total profitable activity for lenders.
It is very clear that banks perform best (at least in the short term) when interest rates are lower.
Lower interest rates also turn savers into speculators. It's more difficult to beat inflation when the rate on a savings account or certificate of deposit (CD) is paying a low rate. Workers will turn more often to equities to try to find ways to counter inflation and grow their nest eggs for retirement. This creates demand for asset management services, brokers, and other money intermediaries.
2. Gross Domestic Product (GDP)
Countries around the world track levels of economic activity through gross domestic product (GDP) calculations. Increases in the level of spending or investments cause GDP to rise, and the financial service sector typically sees increased demand for its goods and services when spending and investment levels go up.
Since GDP is the most common and broadest measure of a region's economy—and it is often considered a lagging indicator—the relationship between any one company's stock and the GDP is tenuous at best. Nevertheless, it is considered a useful benchmark for the overall health of the financial sector.
3. Government Regulation and Fiscal Policy
Government regulation is not necessarily an indicator in the traditional sense; instead, investors should keep an eye toward how regulations and tariffs might impact activity from the financial services sector. Banks, are heavily influenced by reserve requirements, usury laws (Usury laws are regulations governing the amount of interest that can be charged on a loan), insurance and lending guidelines,as well as the possibility of government assistance.
Fiscal policy doesn't affect banks as directly. Rather, it impacts the banks' possible customers and trading partners. Consumer confidence tends to rise during expansionary fiscal policy and fall during contractionary fiscal policy. This could translate into fewer investments, trades, and loans.
4. Existing Home Sales
The existing- home sales report is issued monthly by the National Association of Realtors. It provides banks and mortgage lenders with recent data on sales prices, inventory levels, and the total number of homes sold.
This report often impacts prevailing mortgage rates. Investors in financial services and home construction should see upticks when home sales data is rising.
Well-functioning financial systems have the following characteristics:
- Complete markets. The instruments needed to solve investment and risk management problems are available to trade.
- Liquidity. As asset can be bought and sold quickly (that is, it has marketability, which means an asset's likelihood of being sold quickly) at a price close to the prices for previous transactions (price continuity), assuming no new information has been received. In turn, price continuity requires depth, which means that numerous potential buyers and sellers must be willing to trade at prices above and below the current market price.
- Operational efficiency. Low transaction costs (as a percentage of the value of the trade) include the cost of reaching the market, the actual brokerage costs, and the cost of transferring the asset. This attribute is often referred to as internal efficiency.
- Informational (or external) efficiency. Timely and accurate information is available on the price and volume of past transactions and the prevailing bid-price and ask-price. Prices rapidly adjust to new information; thus the prevailing price is fair because it reflects all available information regarding the asset. Prices will be most informative in liquid markets because information-motivated traders will not invest in information and research if establishing positions based on their analysis is too costly.
Corporate accounts
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