Financial Systems and Institutions

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Financial Systems And

Institutions
References

1. Pathak, Bharati V., Indian Financial System: Markets, Institutions


and Services, Pearson education (Singapore), New Delhi, Second
edition, 2008.
2. Saunders, Anthonu and Cornett, Marcia Millon, Financial
markets and Institutions: An Introduction to the risk
management approach, McGrawHill, Irwin, New York, 2007.
3. Bhole, L.M. , Financial institutions and Markets: Structure,
Growth and Innovations, McGrawHill, New Delhi, Fourth edition,
2008. 
4. Fabozzi, Frank J. and Modigliani, Franco, Capital Markets:
Institutions and Markets, Prentice Hall of India, New Delhi, Third
edition, 2005.
The Financial System
• It plays a vital role in the economic growth of a
country.
• It intermediates between the flow of funds belonging
to those who save a part of their income and those
who invest in productive assets.
• A financial system is a complex, well integrated set of
sub – systems of financial institutions, markets,
instruments and services which facilitates the
transfer and allocation of funds, effectively and
efficiently.
Formal & Informal Financial Sectors
• Most developing countries are characterized by
coexistence and cooperation between both formal as
well as informal sector.
• This is called as ‘Financial Dualism’.
• Formal financial sector – presence of an organized,
institutional and regulated system which caters to the
financial needs of the modern sphere of economy.
• Informal financial sector – unorganized, non-
institutional and non-regulated system dealing with
traditional and rural spheres of economy.
The Indian Financial System
• Broadly classified into Formal (Organized) and
Informal (Unorganized) financial system.
• Formal Financial System comes under the purview of
the Ministry of Finance (MoF), the Reserve Bank of
India (RBI), the Securities Exchange Board of India
(SEBI) and other regulatory bodies.
• Informal Financial System consists of individual money
lenders, group of persons operating as ‘Funds’ or
‘Associations’, partnership firms consisting of local
brokers etc.
The Informal Financial System
• Advantages
- Low Transaction Costs
- Minimum default risk
- Transparency of procedure
• Disadvantages
- Wide range of interest rates
- Higher rates of interest
- Unregulated
Components of the Formal Financial System

• Four segments or components


1. Financial Institutions
2. Financial Markets
3. Financial Instruments
4. Financial Services
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Financial Institutions (Intermediaries)
• The role of financial institutions is to provide financial
services to develop the financial sector and foster
entrepreneurship. A financial institution also focuses
on corporate governance and institution building.

• Financial institutions provide services as


intermediaries of financial markets. They are
responsible for transferring funds from investors to
companies in need of those funds. They also facilitate
the flow of money through the economy.
Financial Institutions (Intermediaries) contd.

• These can be classified into


- Banking - Non-Banking
- Development Financial
- Non-banking Financial Co.
• Also classified as Term Finance – IDBI, ICICI, IFCI, SIDBI, IIBI
• Specialized – Export Import Bank of India (EXIM), Tourist Finance
Corporation of India (TFCI)
• Sectoral – NABARD, National Housing Bank (NHB)
• Investment – Mutual Funds – UTI
• Investment – Insurance – LIC, GIC
• State-level – State Financial Corporation (SFC), State Industrial
Development Corporations (SIDCs)
Financial Markets
• These are the mechanism enabling participants to deal in
financial claims.
• It provide a facility in which their demands and requirements
interact to set a price for such a claim.
• Two types – Money Markets & Capital Market
• Money Markets – Short-term securities
• Capital Markets – Long-term securities
• Also classified as Primary & Secondary Markets
• Primary Markets – New issue
• Secondary Markets – Over the Counter(OTC) and exchange
traded markets
Regulations
• RBI regulates the money markets
• SEBI regulates the capital markets
Financial Instruments
• It is a claim against a person or an institution
for payment, at a future date, of a sum of
money and/or periodic payment in the form of
interest or dividend.
• Distinct features – Marketable, Trade able,
Tailor-made.
• Types of financial securities – Primary and
Secondary
Financial Services
• These services help in borrowing and funding,
lending and investing, buying and selling
securities, making and enabling payments and
settlements, and managing risk exposures in
financial markets.
• Major categories – funds intermediations,
payments mechanism, provision of liquidity,
risk management and financial engineering.
Components of the Formal Financial System

• These 4 sub systems do not work in isolation.


• They are interdependent and interact
continuously with each other.
• Their interaction leads to the development of
a smoothly functioning financial system.
Functions of a Financial System
• Mobilize and allocate savings
• Monitor Corporate Performance
• Provide payment and settlement system
• Optimum allocation of risk-bearing and reduction
• Disseminate price related information
• Offer portfolio adjustment facilities
• Lower the cost of transactions.
• Promote the process of financial deepening and
broadening.
Key Elements of a well-functioning Financial
System
• A strong legal and regulatory environment
• Stable currency
• Sound public finances and public debt mgmt
• A central bank
• Sound banking system
• Information system
• Well-functioning securities market
Types of Financial System Design
- Bank-based - Market-based
• Bank based – Bank dominated system eg:
Germany, where a few large banks play a
dominant role and stock market is not so
important.
• Market based – Market dominated financial
system, as in US, where financial markets play
an important role while the banking industry is
much less concentrated.
Bank-based Financial System
• Advantages
- Close relationship with parties
- Provide tailor-made contracts
- Efficient intertemporal risk sharing
- No free rider problem
• Disadvantages
- Retards innovation and growth
- Impedes competition
Market-based Financial System
• Advantages
- Provides attractive terms to both investors and
borrowers.
- Facilitates diversification
- Allows risk sharing
- Allows financing of new technologies
• Disadvantages
- Prone to instability
- Exposure to market risk
- Free-rider problem

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