Financial_system

Financial System

Definition: A financial system is the institutional arrangement that mobilizes financial surpluses from units generating surplus income to those in need of funds. This system is crucial for facilitating economic activities by providing a mechanism through which individuals and organizations can access the funds they require for investment, consumption, and growth.

Activities Involved Include:

• Production, distribution, exchange, and holding of various financial assets/instruments: These activities encompass everything from the creation of financial products like stocks and bonds to their trading and the management of financial risk.

• Participation from financial institutions, banks, and intermediaries: These entities play a vital role by providing services such as loans, investment products, and facilitating transactions.

• Comprises financial markets, financial assets, financial services, and financial institutions: The financial system is an integrated network of various components that interact to foster economic growth and stability.

Functions of a Good Financial System

Key Functions Include:

• Regulation of currency: Ensures stability in the currency system, which underpins economic activity.

• Banking functions: Facilitate deposits, loans, and payment processing.

• Performance of agency services and custody of cash reserves: Institutions act on behalf of clients to manage their investments and cash flow.

• Management of national reserves of international currency: This involves holding foreign currency reserves to manage exchange rates and ensure international trade stability.

• Credit control mechanisms: Regulate the availability of credit to prevent over-leveraging and maintain economic stability.

• Administering national, fiscal, and monetary policies: Ensures fiscal responsibility and the proper functioning of economic mechanisms to maintain growth.

• Supply and deployment of funds for productive use: Invests excess savings into areas that promote economic activity, such as businesses and infrastructure.

• Maintaining liquidity in the system: Ensures enough cash flow is available to meet everyday financial obligations.

Organisational Structure of Financial System

Key Constituents:

• Financial Markets: Where securities are issued and traded, providing platforms for exchanging financial assets.

• Financial Products: Instruments that represent a claim on future cash flows, including loans, stocks, and bonds.

• Market Participants: Includes banks, investment firms, and individual investors that contribute to the functioning of the financial market.

Financial Markets

Role of Financial Markets:

• Facilitate the allocation of savings to investments: Channels savings into domains that promise a return, thereby optimizing capital utilization.

• Efficient transfer of resources from those with idle resources to those in need: Ensures that money flows towards projects that will generate economic value.

• Provide a variety of assets and fundraising options: Supports innovation by enabling different types of financial instruments that cater to various risk appetites and investment strategies.

• Contribute to economic development through enhanced rates of saving and investment: By providing more opportunities and confidence in investment, relates strongly to GDP growth.

Importance of Financial Markets:Benefits Offered:

• Provide access to capital for individuals, companies, and organizations: Financing options empower various economic entities to grow and develop.

• Fair treatment assurance by financial regulators: Protects investors' interests, creating a trustworthy market environment.

• Creation of jobs through direct and indirect market activities: The financial sector sustains numerous jobs in brokering, underwriting, compliance, and investment.

Functions of Financial Markets

Specific Functions Include:

• Put savings into productive use: Efficiently directs money from savers to borrowers.

• Determine the pricing of securities: Market forces of supply and demand establish fair prices for financial instruments.

• Enhance liquidity of financial assets: High liquidity allows for quick buy/sell transactions without significantly affecting security pricing.

• Reduce transaction costs: Streamlined operations and competitive pricing lower the cost associated with buying and selling financial instruments.

Role of Financial Markets in Economic Development

Importance for Economic Development:

• Capital essential for development sourced through capital markets: Fresh capital becomes available through instruments like stocks, encouraging innovation and growth.

• Funds flow from surplus to deficit: Creates a bridge between those who have excess capital and those who require funding for various projects.

• Essential for price discovery and resource mobilization through IPOs: Analyzes investor sentiment and overall market conditions, promoting efficient capital allocation.

Types of Financial Markets

1. Money Market:

   • Provides short-term funding and investments for up to one year, facilitating transactions in instruments like treasury bills and commercial paper.

2. Capital Market:

   • Focuses on long-term investments with maturities exceeding one year, dealing in stocks and bonds.

3. Securities Market:

   • Encompasses both the primary and secondary markets, focusing on securities trading.

Capital Market Functions

Vital Functions:

• Mobilize resources for investments: Helps channel funds into profitable ventures.

• Facilitate buying and selling of securities: Ensures liquidity for investors.

• Efficient price discovery: Establishes fair prices for securities based on demand/supply dynamics.

• Enable timely transaction settlements: Supports the systematic clearing and processing of transactions.

Segments of the Capital Market

Primary Market:

• New securities are issued and sold for the first time through mechanisms like Initial Public Offerings (IPOs) for raising initial capital.Secondary Market:

• Involves trading of existing securities among investors, allowing for capital gain opportunities without new capital raised.

Primary Market vs. Secondary Market

Primary Market:

• Involves the issuance of new securities directly by companies to raise funds for expansion or new projects.Secondary Market:

• Trade of pre-existing securities occurs; funds move between investors without benefiting the issuing company.

Types of Issues in Public Offerings

• Public Issue: Offers securities to the general public, sharing ownership stakes with a broad audience.

• Initial Public Offer (IPO): The debut issuance by a private company transitioning to public ownership.

• Further Public Offer (FPO): An additional offering by an already listed company to raise further capital.

• Rights Issue: Existing shareholders offered new shares, usually at a discount, to purchase more equity.

• Bonus Issue: Shares given to existing shareholders at no cost, typically from accumulated earnings.

• Private Placement: A targeted offer to select investors, such as institutions, limiting public access.

Underwriting and Intermediaries to Capital Markets

Role of different intermediaries in public issues includes:

• Merchant Bankers/Lead Managers: Manage the whole process of securities issuance, ensuring regulatory compliance.

• Underwriters: Guarantee that a minimum percentage of shares will be sold, absorbing risk.

• Bankers to an Issue: Administer application funds and ensure proper allocation and refund procedures.

• Brokers: Facilitate trades on behalf of clients in acquiring or selling securities.

• Debenture Trustees: Safeguard the rights of debenture holders and ensure compliance with rules governing debt instruments.

• Regulators and Compliance: Entities like SEBI maintain market integrity, overseeing operations, and protecting investor interests.

Overview of IPO Grading

IPO Grading Purpose: Provides investors with an assessment of the fundamental value of equity issues, assisting in investment decisions.Grading Scale: Ranges from 1 (Poor) to 5 (Strong), indicating the relative strength of the fundamentals.

• IPO grading acts as a guideline, rather than a direct investment suggestion, emphasizing due diligence.

• Unlisted companies must disclose pertinent information before obtaining grading approval.

Procedures and Regulations for IPOs

• Filing processes for draft offer documents with SEBI: Companies must submit detailed disclosures regarding their business and the securities offered.

• Importance of public comments prior to finalizing offer documents: Encourages transparency and addresses potential issues raised by investors or the public.

• ASBA Process: Facilitates subscription to public issues by blocking funds in investor accounts, streamlining the process for both investors and issuers.

• Eligibility criteria and obligations of investors wishing to apply via ASBA: Outlines the compliance expectations for individuals wishing to participate in public offerings.

Green Shoe Option

• Mechanism for overselling shares to stabilize price post-IPO: Allows underwriters to sell more shares than originally planned, which can be repurchased later if stock price falls.

• Helps maintain stability in the share price after the IPO, providing investor confidence.

• The concept originated with Green Shoe Manufacturing Company in the US and was adapted by SEBI in India in 2003, enhancing market robustness.