The Financial System: Centre For Financial Management, Bangalore

Chapter 2 THE FINANCIAL SYSTEM
Centre for Financial Management ,
OUTLINE
Functions of the Financial System Financial Assets Financial Markets Financial Market Returns Financial Intermediaries Regulatory Infrastructure
THE FINANCIAL SYSTEM

Fund s Deposits/Sha res
Financial Institutions Commercial Banks Insurance Companies Mutual Funds Provident Funds Non-Banking Financial Companies
Fund s Loan s
Suppliers of Funds Individuals Businesses Governments
Demanders of Funds Individuals Businesses Governments
Fund s Securiti es
Financial Markets Money Market Capital Market
Fund s Securiti es
FUNCTIONS OF THE FINANCIAL SYSTEM
Payment System Pooling of Funds Transfer of Resources Risk Management Price Information for Decentralised
Decision Making
Dealing with Incentive Problem


Payment System Depository financial intermediaries such as banks are the pivot of the payment system. Credit card companies play a supplementary role. Pooling of Funds Financial markets and intermediaries facilitate the pooling of the household savings for financing business. Transfer of Resources The financial system facilitates the efficient lifecycle allocations of household consumption, the efficient allocation of physical capital to its most productive use, and the efficient separation of ownership from management.

Risk Management A well-developed financial system offers a variety of instruments that enable economic agents to pool, price, and exchange risk The three basic methods of managing risk are : hedging, diversification, and insurance Price Information for Decentralised Decision Making Interest rates and security prices are used by households in their consumption-savinginvestment decisions and by firms in their investment and financing decisions

Dealing with Incentive Problems Information asymmetry leads to moral hazard and adverse selection, which are broadly referred to as agency problems. Financial problem intermediaries of informational like banks and by
venture capital organizations can solve the asymmetry handling sensitive information discreetly and
FINANCIAL SECTOR REFORMS IN INDIA The financial sector reforms initiated from the early 1990s have focused on the following objectives:

Removal of financial repression.
Creation of an efficient, productive, and profitable financial sector.

Evolution of market-determined interest rates.
Granting of operational and functional autonomy to institutions. Opening of operational and functional autonomy to institutions.

Opening up of the external sector in a calibrated fashion.

FINANCIAL ASSETS
Financial
assets
are
intangible
assets
that represent claims to future cash flows. The terms financial asset, instrument, or security are used interchangeably
Examples : A 10-year bond issued by the GOI
carrying an interest Centre for rate of 7 percent. Financial Management ,
FINANCIAL MARKETS
A financial
market
is
market
for
creation and exchange of financial assets.
Financial markets play a very pivotal role in allocating they :

resources in the economy by
performing three important functions as
FUNCTIONS OF FINANCIAL MARKETS

Facilitate Price Discovery The continual interaction among numerous buyers and sellers who participate in financial markets helps in establishing the prices of financial assets Provide Liquidity Thanks to the liquidity provided by financial markets, it is possible for companies (and other entitities) to raise long-term funds from investors with short-term horizons Reduce the Costs of Transacting Financial markets considerably reduce the following costs of transacting Search cost Information cost
CLASSIFICATION OF FINANCIAL MARKETS

DEBT MARKET NATURE OF CLAIM EQUITY MARKET MONEY MARKET MATURITY OF CLAIM CAPITAL MARKET PRIMARY MARKET SEASONING OF CLAIM SECONDARY MARKET CASH OR SPOT MARKET TIMING OF DELIVERY FORWARD OR FUTURES MARKET EXCHANGE-TRADED MARKET ORGANISATIONAL STRUCTURE OVER-THE-COUNTER MARKET
FINANCIAL MARKET RETURNS Interest Rate Function of the unit of account, maturity, and default risk
Rate of Return on Risky Assets Cash dividend Ending price Beginning price r= + Beginning Beginning price price Capital yield Dividend yield Inflation and RealFinancial Management , Centre for Interest Rate
DETERMINANTS OF RATES OF RETURN
Expected Productivity of Capital Degree of Uncertainty about the
Productivity of Capital
Time Preferences of People Degree of Risk Aversion

EQUILIBRIUM IN FINANCIAL MARKETS

(a) Supply and demand for loanable funds and determination of interest rate Interest rate ie i e Sf (lending)
Sf
Df (borrowi ng) 0 A B Amount of loanable funds
(b) Supply and demand for securities and determination of prices Pric e P e P e
SS (borrowing)
Ds Ds (lending) 0 A Amount of securities B
FINANCIAL INTERMEDIARIES
Reserve Bank of India Commerci al banks
Development al financial institutions
Insurance companies
Other public sector financial institutions
Mutual funds
Non-banking financial corporations
Public sector banks
All India institutions
Life Insurance Corporation of India Private sector insurance companies
POSB
Unit Trust of India
Publi c secto r firms
NABARD
Private sector banks
State level institutions
NHB General Insurance Corporation of India
Other mutual funds
Privat e sector firms
RATIONALE FOR FINANCIAL INTERMEDIARIES
Diversification Lower Transaction Cost Economies of Scale Confidentiality Signalling
RATIONALE FOR FINANCIAL INTERMEDIARIES

Diversification The pool of funds mobilised by financial intermediaries is invested in a broadly diversified portfolio of assets (loans, stocks, bonds and so on). Lower Transaction Cost The transaction cost in percentage terms decreases as the transaction size increases. Economies of Scale Financial institutions enjoy economies of scale Confidentiality Information shared with financial intermediaries may be kept confidential whereas information disclosed to numerous individual investors is in Centre for Financial Management , public domain.
REGULATARY INFRASTRUCTURE
RESERVE BANK OF INDIA SEBI
KEY TRENDS IN THE INDIAN FINANCIAL SYSTEM Market-determined interest rates and greater volatility of interest rates Emergence of universal banks Emphasis on prudential regulation and supervision Gradual integration with the global financial system Increase in financial innovation Centre for Financial Management ,
SUMMING UP
The financial system consisting of a variety of institutions, markets, and instruments related in a systematic manner provides the principal means by which savings are transformed into investments.

The financial system provides a payment mechanism,
enables the pooling of funds, facilitates the management of uncertainty, generates information for decentralised decision making, and helps in dealing with informational asymmetry.
Financial assets represent claims against the future
income and wealth of others. Financial liabilities, the counterparts of financial assets, represent promises to pay some portion of prospective income and Centre for Financial Management ,
There are different ways of classifying financial markets. The important bases for classification are: type of financial claims, maturity of claims, new issues versus outstanding issues, timing of delivery, and nature of organisational structure.

The interest rate on any type of loan (or fixed income
security) depends on several factors, the most important being the unit of account, the maturity, and the default risk.
Just as a distinction is made between nominal and real
prices, so too a distinction is made between nominal and real interest rates. The nominal interest rate on a bond is the rate of return in nominal terms whereas the real rate is the nominal rate adjusted for the inflation factor.
Despite a good deal of deregulation in recent years, interest rates in India continue to be substantially regulated.

Financial intermediaries are firms that provide services
and products that customers may not be able to get more efficiently by themselves in financial markets.
Financial intermediaries seem to offer several
advantages : diversification, lower transaction cost, economies of scale, confidentiality, and signaling benefit.
The major financial intermediaries in India are
commercial banks, developmental financial institutions, insurance companies, mutual funds, non-banking financial companies, and merchant banks.
As a maker and enforcer of laws in a society, the


The Financial System: Centre For Financial Management, Bangalore

Uploaded by

Copyright:

Available Formats

The Financial System: Centre For Financial Management, Bangalore

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

The Financial System: Centre For Financial Management, Bangalore

Uploaded by

Copyright:

Available Formats

Chapter 2 THE FINANCIAL SYSTEM

Centre for Financial Management ,

Centre for Financial Management ,