Course Objective

To make students aware of various aspects of a financial system like banking, insurance, mutual funds, capital markets, portfolio management etc. To provide students with an understanding of various trading and settlement regulations in both domestic as well as international markets To enable students to apply theoretical knowledge into the real world To enable students to apply various skills like information technology, accounting etc. to develop analytical skills in financial services To develop an ability to access and assimilate information and update knowledge in financial markets.
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Course outline
Introduction to the Financial system Financial services provided by Banks Trading and settlement in stock markets Mutual fund schemes and comparison of mutual funds Merchant banking, book building, initial public offer (IPO) Insurance plans, Unit linked Insurance plans (ULIP), schemes in insurance International financial markets Issue of ADR and GDR

Financial System Definition

A system is a set of interrelated parts working together to achieve some purpose A financial system is a set of complex or closely connected or inter mixed institutions, agents, practices, markets, claims and so on in any economy. It can therefore be defined as that part of the economy which includes all the institutions involved in moving savings from savers (households and firms) to borrowers, and in transferring, sharing, and insuring risks; it includes financial institutions / intermediaries like banks, insurance organizations, unit trusts/ mutual funds markets, bond markets, and the stock market which collect capital from savers/investors and distribute them to the entrepreneurs / productive enterprises

Constituents of a financial System

Components of financial systems
Formal systems
Financial institutions Financial markets Financial instruments

Informal systems

Basic functions of financial systems

Financial systems are of crucial significance to capital formation which in turn is indispensable for economic growth Process of capital formation involves three distinct although interrelated activities
Savings ability by which claims to resources are set aside and become available for other purposes Finance The activity by which resources are assembled from domestic savings or obtained from abroad, or specially created usually as bank deposits or notes and then placed in the hands of investors Investments The activity by which resources are committed to production

There are three types of economic units

Saving surplus units Savings deficit units Neutral units

If capital formation has to take place savings must be transferred from saving surplus units to savings deficit units. Financial systems act as a link between savers and investors and thereby aid capital in capital formation

Role of financial intermediaries

Indirect finance refers to the flow of savings from the savers to entrepreneurs through intermediary financial institutions like mutual funds, insurance companies etc. Financial intermediaries come in between the ultimate borrowers and ultimate lenders in the savings investment process Financial intermediaries play a vital role in economic development via the capital formation process. Their relevance to the flow of savings is derived from what is called transmutation effect that is the ability to convert contracts with a given set of features into contracts with different features. Financial intermediaries provide services for mobilization of savings as well as their channelization Services provided under mobilization of savings are
Convenience
Divisibility maturity

Lower risk Expert management Economics of scale

Financial intermediaries play a crucial role in the economic development by directing savings in tune with developmental priorities

Financial intermediaries
Important intermediaries operating in the financial markets include;
investment bankers, underwriters, stock exchanges, registrars, depositories, custodians, portfolio managers, mutual funds, financial advertisers, financial consultants, primary dealers, satellite dealers,

Though the markets are different, there may be a few intermediaries offering their services in more than one market e.g. underwriter. However, the services offered by them vary from one market to another.

FINANCIAL INTERMEDIATION

Intermediary Stock Exchange Investment Bankers Underwriters

Market Capital Market Capital Market, Capital Market, Market

Registrars, Depositories, Capital Market Custodians Primary Dealers Satellite Money Market Dealers Forex Dealers Forex Market

Role Secondary Market to securities Corporate advisory services, Credit Market Issue of securities Money Subscribe to unsubscribed portion of securities Issue securities to the investors on behalf of the company and handle share transfer activity Market making in government securities Ensure exchange ink currencies

Functions of Financial Institutions and Markets

Assemble funds Allocate capital
Interest rates and prices of financial instruments Quantities to borrowers and lenders

Absorb risk Analyse and disseminate expensive and financial information

Risk of debt and equity issues and issuers Valuation of debt and equity Valuation of derivatives Volumes of debts and equities Ownership of debts and equities Monitor primary issuer performance

Distribute Primary Securities

Investigate issuers of debts and equities as to their future performance Underwrite securities i.e. guarantee a price for the security issue and accept the risk of security issue Wholesale distribution of security to underwriters and dealers Retail distribution of securities through a sale to the open market via brokers and dealers
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Functions of Financial Institutions and Markets (cont.)

Provide for secondary market for primary, secondary and derivative securities. The secondary market is the market for outstanding securities where most trading takes place Intermediate between the preferences of primary security issuers and ultimate savers Other functions
Maturity intermediation Reducing risk via diversification Reducing the cost of contracting and information processing Providing a payment mechanism Asset / Liability management

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Relationship between financial system and economic growth

Existence of financial system facilitates economic activity and growth. Markets, institutions and instruments are the prime movers of economic growth. Financial system diverts savings to productive uses, it helps to increase output of the economy Helps accelerate the volume and rate of savings by providing diversified range of financial instruments and services Makes innovation least costly and most profitable thereby enabling a faster economic growth Financial system is useful in evaluating assets, increasing liquidity and producing and spreading information Economic growth in turn develops financial system as they increase trading activities and develop new risk management products to keep pace with growth
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Relationship between financial system and economic growth (cont.)

Financial markets represent deep end of the financial system; deeper the system, greater the stability and resilience. A well developed money and govt. securities market helps the Central Bank to conduct monetary policy effectively with the help of market based instruments The financial system plays an important role in disciplining and guiding management of companies leading to sound corporate governance The domestic financial system when linked to international financial system, increases capital flow with the help of financial markets. This link reduces risk through portfolio diversification and helps in accelerating economic growth There is a symbiotic relationship between financial system and economic growth. A sophisticated and sound financial accelerates economic growth and the financial system in turn develops more with economic growth
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Relationship between financial system and economic growth

Market frictions
Information costs Transactions cost Financial markets and intermediaries Financial market Functions (Services)
Liquidity Risk diversification Rapid information Corporate control Savings mobilisation

Channels to growth Capital accumulation Technological innovations Economic Growth

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Financial institutions
Banking institutions
Scheduled Commercial Banks
Public Sector Banks Private Sector Banks Foreign Banks Regional rural Banks

Scheduled Co-operative

Non banking institutions

Non Banking Financial Companies Development Financial Institutions
All India Financial Institutions ( IDBI, IFCI, IIBI, NABARD,SIDBI, NHB etc) State Level institutions ( SFCs, SIDCs) Other Institutions (DICGC,ECGC)

Mutual Funds
Public Private

Insurance and housing finance companies

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Financial Markets
A Financial Market can be defined as the market in which financial assets are created or transferred. As against a real transaction that involves exchange of money for real goods or services, a financial transaction involves creation or transfer of a financial asset. Financial Assets or Financial Instruments represents a claim to the payment of a sum of money sometime in the future and /or periodic payment in the form of interest or dividend. Money Market- The money market ifs a wholesale debt market for low-risk, highly-liquid, short-term instrument. Funds are available in this market for periods ranging from a single day up to a year. This market is dominated mostly by government, banks and financial institutions. Capital Market - The capital market is designed to finance the long-term investments. The transactions taking place in this market will be for periods over a year. Forex Market - The Forex market deals with the multicurrency requirements, which are met by the exchange of currencies. Depending on the exchange rate that is applicable, the transfer of funds takes place in this market. This is one of the most developed and integrated market across the globe. Credit Market- Credit market is a place where banks, FIs and NBFCs purvey short, medium and long-term loans to corporate and individuals.

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Financial Markets (contd.)

Capital Market
Equity
Primary
Public issues Private placement Domestic International

Secondary NSE, BSE, OTCI, ISE, Regional Stock exchanges Derivatives

Exchange traded - Futures and options
Index, Stock

Debt
Private Corporate PSU Bond Government securities market
Primary, Secondary

Money Market
Treasury Bills, Call Money Market Commercial bills Commercial Papers Certificates of deposits Term money
Primary Segment Secondary Segment

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Money Market Instruments

1. Call /Notice-Money Market Call/Notice money is the money borrowed or lent on demand for a very short period. When money is borrowed or lent for a day, it is known as Call (Overnight) Money. Intervening holidays and/or Sunday are excluded for this purpose. Thus money, borrowed on a day and repaid on the next working day, (irrespective of the number of intervening holidays) is "Call Money". When money is borrowed or lent for more than a day and up to 14 days, it is "Notice Money". No collateral security is required to cover these transactions. 2. Inter-Bank Term Money Inter-bank market for deposits of maturity beyond 14 days is referred to as the term money market. The entry restrictions are the same as those for Call/Notice Money except that, as per existing regulations, the specified entities are not allowed to lend beyond 14 days. 3. Treasury Bills. Treasury Bills are short term (up to one year) borrowing instruments of the union government. It is an IOU of the Government. It is a promise by the Government to pay a stated sum after expiry of the stated period from the date of issue (14/91/182/364 days i.e. less than one year). They are issued at a discount to the face value, and on maturity the face value is paid to the holder. The rate of discount and the corresponding issue price are determined at each auction.
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Money Market Instruments (contd.)

4. Certificate of Deposits Certificates of Deposit (CDs) is a negotiable money market instrument issued in dematerialised form or as a Usance Promissory Note, for funds deposited at a bank or other eligible financial institution for a specified time period. CDs can be issued by
scheduled commercial banks excluding Regional Rural Banks (RRBs) and Local Area Banks (LABs); and select all-India Financial Institutions that have been permitted by RBI to raise short-term resources within the umbrella limit fixed by RBI. Banks have the freedom to issue CDs depending on their requirements. An FI may issue CDs within the overall umbrella limit fixed by RBI, i.e., issue of CD together with other instruments viz., term money, term deposits, commercial papers and intercorporate deposits should not exceed 100 per cent of its net owned funds, as per the latest audited balance sheet.

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Money Market Instruments (contd.)

5. Commercial Paper CP is a note in evidence of the debt obligation of the issuer. On issuing commercial paper the debt obligation is transformed into an instrument. CP is thus an unsecured promissory note privately placed with investors at a discount rate to face value determined by market forces. CP is freely negotiable by endorsement and delivery. A company shall be eligible to issue CP provided
the tangible net worth of the company, as per the latest audited balance sheet, is not less than Rs. 4 crore; the working capital (fund-based) limit of the company from the banking system is not less than Rs.4 crore and the borrowal account of the company is classified as a Standard Asset by the financing bank/s.

The minimum maturity period of CP is 7 days. The minimum credit rating shall be P-2 of CRISIL or such equivalent rating by other agencies.

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Money Market Instruments (contd.)

Capital Market Instruments The capital market generally consists of the following long term period i.e., more than one year period, financial instruments; In the equity segment Equity shares, preference shares, convertible preference shares, non-convertible preference shares etc and in the debt segment debentures, zero coupon bonds, deep discount bonds etc. Hybrid Instruments Hybrid instruments have both the features of equity and debenture. This kind of instruments is called as hybrid instruments. Examples are convertible debentures, warrants etc.
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Financial Instruments/ Assets/Securities

Equity / Ordinary shares Debentures Preference shares Innovative instruments
Issued by companies
Participating debentures Convertible debentures with options Third party convertible debentures Convertible debentures redeemable at premium Debt equity swaps Secured premium notes with detachable warrants Zero coupon convertible notes Non convertible debentures with detachable equity warrants Zero interest fully convertible debentures Fully convertible debentures with interest Warrants

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Innovative instruments contd.

Issued by Financial institutions
Floating rate bonds Zero coupon bonds / Deep discount bonds Easy exit bond with a floating interest rate Easy exit bonds with floating interest rates Regular income bonds Retirement bonds Set up liquid bonds Growth bonds Index bonds Capital gains bonds Encash bonds

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Opportunities of the 21st Century

New technology
Proliferation of new services Development of new market areas Reduction of operational costs

Globalization
Growth of international financial institutions Increased competition for customers and markets

Specialized niches for boutique firms Continuing Consumer Concerns

Bigger is not necessarily better (service) Security of personal financial information
Identity theft Damaging credit reports

Bad management of large financial institutions can lead to:

Loss of funds Loss of credit Widespread negative economic impact

Financial Assets versus Real Assets

A financial asset is a contract that offers a promise of payment (or the option to receive payment) in the future from the party that issued the contract. Examples include securities, loans, etc. Real assets are those assets expected to provide benefits based on their fundamental qualities. Examples include inventory, real estate, etc.

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Differences between Financial Institutions and Non-financial Firms

Depository Institutions Assets Most assets are financial assets Non-financial Firms Most assets are real assets

Financing of the firm

High financial leverage is normal and advantageous

Moderate financial leverage is normal; high is dangerous

Asset Liquidity Liability Liquidity

Very High

More moderate

Quite High

More moderate

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Types of Financial Institutions

Non-Depository Institutions Depository Institutions1 Finance companies
Commercial banks Thrift institutions
Savings & loan associations Savings banks

Contractual intermediaries

Pension funds Insurance companies

Credit unions

Investment companies
Mutual fund management companies Real estate investment trusts (REITs)

1Depository

institutions take deposits and make loans.

Securities firms
Securities brokers Investment banks

Governmentsponsored enterprises
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Depository Institutions
Depository Institutions
are financial institutions that take deposits and make loans control the largest proportion of financial assets.

Depositors are protected from loss of funds by deposit insurance via quasi-federal agencies
Builds depositors confidence in financial system Provides another level of regulatory oversight

Commercial Banks Banks hold primarily securities and loans as assets Banks have been the primary source of short-term and intermediate-term loans Their loan portfolio is the most diversified and credit risk is their largest risk Banks major source of funds are customer deposits

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Depository Institutions (contd)

Thrift Institutions
Savings and loan associations (S&Ls) and savings banks traditionally rely on savings deposits as sources of funds. S&Ls have expanded beyond their traditional role as mortgage suppliers. Savings banks resemble S&Ls, but they have more diversified asset bases.

Credit Unions (CUs)

CUs are not-for-profit organizations CUs are subject to a common bond requirement and cannot make commercial loans CUs have aggressively stretched common bond boundaries, becoming more like banks by offering credit cards and other investment services

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Depository Institutions (contd)

Finance Companies
Finance companies provide
Loans to businesses and consumers who can not qualify for bank loans Provide liquidity to businesses by financing their most liquid assets (accounts receivable) Loans at higher interest rates than banks

Major sources of funds include

Loans from commercial banks Selling commercial paper and bonds

Contractual Intermediaries
Operate under formal agreements with policyholders or pensioners who entrust their funds to these firms. Provide financial vehicles for
Risk management Retirement savings

Defined contribution retirement plans have largely replaced defined benefit plans Assets are primarily long term investments

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Depository Institutions (contd)

Investment Companies
Investment companies include mutual funds, money market funds, and REITs Provides professional management of diversified portfolios to individual investors Economies of scale offer the benefits of:
professional management reduced costs reduced risk exposure within large, diversified portfolios.

Securities Firms
Provide retail brokerage services including buying and selling stocks, bonds, and other financial assets for customers Make a market in financial securities by buying and selling the same securities themselves Sell investment banking services including the creation and issuance of new securities (individual public offerings or IPOs) Provide financial consulting services

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Industry Differences
Major differences exist between financial institutions in their
Asset and liability distributions Services offered to the public Riskiness of invested funds Legal structure

There are significant differences in the laws regulating their operations and government agencies acting as regulators. Economic Functions of financial Institutions
Intermediation (transfer of funds, securities) Reduced transactions and information costs Liquidity
For markets For individual parties (companies or individuals)

Information and contacts Transfer of risk Creation of financial instruments Creation of money

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Primary versus Secondary Securities and Markets

For securities
Primary (direct) securities are claims against individuals, governments, and nonfinancial firms. Secondary (indirect) securities are financial liabilities of financial institutions.

For Markets
Primary markets: Securities are initially offered (IPO) and issuing party receives the funds Secondary markets: Outstanding securities are traded from one holder to another and issuing party receives no funds.

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Primary and Secondary Securities

Primary Securities Commercial Loans Mortgage Loans Consumer Loans Government Bonds Secondary Securities Savings Deposits Transaction Deposits Certificates of Deposit Insurance Policyholders Reserves

Corporate Bonds

Mutual Fund Shares

Corporate Common Stock

Pension Fund Reserves

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Financial Intermediation Benefits

Reduction of transactions and information costs
Information and Search Costs Portfolio Selection and Denomination Costs Monitoring Costs Risk Management Costs Maturity Intermediation and Liquidity

Exchange of securities with different characteristics Transfer of risk Search Costs

Financial institutions provide ways to identify entities with excess funds and those needing funds. This identification by financial institutions eliminates the need for individual lenders and borrowers to find one another.

Portfolio Selection Costs

Investors may wish to invest in financial assets in different dollar amounts, with different maturities, or with different risk levels from the financial liabilities borrowers wish to issue. Financial institutions issue secondary securities to lenders, and then repackage funds in forms attractive to borrowers.

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Financial Intermediation Benefits (contd.)

Monitoring Costs
Asymmetric information exists when managers have one set of information and investors have a different set of information. Managers are generally better informed about their firms prospects, so they generally have a better set of information. Information asymmetry gives rise to monitoring costs ongoing expenses incurred by investors to gather information so they can intervene if borrowers financial situations change. Investors can avoid the risk of a single party defaulting on its obligations by holding shares in a mutual fund Insurance companies can pool premiums and provide risk management at much lower cost Banks provide letters of credit that guarantee payment by other parties, reducing risk Investment and commercial banks provide instruments that can protect against interest rate and foreign exchange risk

Risk Management Costs

Maturity Intermediation and Liquidity

Banks accept small amounts from small investors as deposits and transform them into longer-term loans Banks borrow short-term (from depositors) and lend longer-term Checks, credit cards, electronic payments, and bank wires can be used to make payments in lieu of cash
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The Changing Role of Financial Institutions in the Technological Age

New risks with technology Societal Concerns
Serving the community Services for the unbanked Community Reinvestment Act

Accounting & Ethical Concerns

Enron Arthur Anderson Investment bankers providing false information Mutual fund management practices Corporate Governance Scandals

Financial Institution Management

Who sets objectives?
Stockholders versus stakeholders Normative versus positive theory approach Agency theory Customer needs Regulations providing limits

What is the goal of the firm?

Economic Value Added (EVA)

A goal for risk-profitability management Measures profitability after
Long term debtholders earn their return Stockholders and other investors earn their return

Can be used for individual capital allocation decisions

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