Financial System Notes

The Financial System: An Introduction

Introduction

  • A financial system is crucial for a country's economic growth.
  • It acts as an intermediary between savers and investors, mobilizing and allocating scarce resources efficiently.
  • It comprises financial institutions, markets, instruments, and services, facilitating effective fund transfer and allocation.

Formal and Informal Financial Sectors

  • Most developing countries exhibit financial dualism, with formal and informal sectors coexisting.
  • The formal sector is organized, institutional, and regulated, catering to modern economic needs.
  • The informal sector is unorganized, non-institutional, and unregulated, serving traditional and rural economies.
  • The informal sector arises from economic and social dualism and financial repression, offering flexibility, low transaction costs, minimal default risk, and transparency.
  • Higher interest rates prevail in the informal sector due to these advantages.
  • Interpenetration exists between the formal and informal systems regarding operations, participants, and activities.
  • Prioritizing the development of an efficient formal financial system is essential for lower intermediation costs and broader services.

The Indian Financial System

  • The Indian financial system consists of formal (organized) and informal (unorganized) sectors.
  • The formal financial system is regulated by the Ministry of Finance (MoF), the Reserve Bank of India (RBI), the Securities and Exchange Board of India (SEBI), and other regulatory bodies.
  • The informal financial system includes:
    • Individual moneylenders (neighbors, relatives, landlords, traders, storeowners).
    • Groups operating as 'funds' or 'associations' with their own rules.
    • Partnership firms of local brokers, pawnbrokers, and non-bank financial intermediaries (finance, investment, and chit-fund companies).
  • The spread of banking in rural areas has expanded the formal financial system's reach.

Components of The Formal Financial System

The formal financial system comprises four segments:

  • Financial institutions
  • Financial markets
  • Financial instruments
  • Financial services
Financial Institutions
  • Intermediaries that mobilize savings and allocate funds efficiently.
  • Classified as banking and non-banking financial institutions.
    • Banking institutions: creators and purveyors of credit; liabilities are part of the money supply.
    • Non-banking financial institutions: purveyors of credit; liabilities may not be part of the money supply.
  • Major institutional purveyors of credit in India:
    • Developmental Financial Institutions (DFIs).
    • Non-Banking Financial Companies (NBFCs).
    • Housing Finance Companies (HFCs).
  • Term-finance institutions:
    • Industrial Development Bank of India (IDBI).
    • Industrial Credit and Investment Corporation of India (ICICI).
    • Industrial Financial Corporation of India (IFCI).
    • Small Industries Development Bank of India (SIDBI).
    • Industrial Investment Bank of India (IIBI).
  • Specialized finance institutions:
    • Export-Import Bank of India (EXIM).
    • Tourism Finance Corporation of India (TFCI).
    • ICICI Venture.
    • Infrastructure Development Finance Company (IDFC).
  • Sectoral financial institutions:
    • National Bank for Agricultural and Rural Development (NABARD).
    • National Housing Bank (NHB).
  • Investment institutions:
    • Unit Trust of India (UTI).
    • Public and private sector mutual funds.
    • Life Insurance Corporation (LIC).
    • General Insurance Corporation (GIC) and its subsidiaries.
  • State-level financial institutions:
    • State Financial Corporations (SFCs).
    • State Industrial Development Corporations (SIDCs) - owned and managed by state governments.
  • Post-reforms era: convergence of activities; banks undertaking non-bank activities and vice versa.
  • Most financial institutions now raise funds from financial markets.
Financial Markets
  • Mechanisms enabling participants to deal in financial claims and set prices.
  • Main organized financial markets in India:
    • Money Market: short-term securities (maturity of one year or less).
    • Capital Market: long-term securities (maturity of more than one year).
  • Classified as primary and secondary markets.
    • Primary Market: deals with new issues.
    • Secondary Market: trades outstanding securities.
  • Components of the secondary market:
    • Over-the-Counter (OTC) market: negotiated spot trades for immediate delivery and payment (e.g., government securities market).
    • Exchange-traded market: trading over a trading cycle in stock exchanges.
    • Derivatives market (exchange-traded): recently emerged.
Financial Instruments
  • A claim against a person or institution for future payment of money and/or periodic payments (interest or dividend).
  • Represent paper wealth (shares, debentures, bonds, notes).
  • Many are marketable, denominated in small amounts, and traded in organized markets.
  • Enable portfolio diversification to reduce risk.
  • Defined under the Securities Contracts Regulation Act (SCRA), 1956, including:
    • Shares, scrips, stocks, bonds, debentures, debenture stocks, and other marketable securities of similar nature of any incorporated company or body corporate
    • Government securities
    • Derivatives of securities
    • Units of collective investment scheme
    • Security receipts
    • Interest and rights in securities
    • Any other instruments declared by the central government
  • Financial securities: negotiable and tradeable financial instruments.
    • Primary (direct) securities: Issued directly by ultimate borrowers to ultimate savers (e.g., equity shares and debentures).
    • Secondary (indirect) securities: Issued by financial intermediaries to ultimate savers (e.g., bank deposits, mutual fund units, and insurance policies).
  • Differ in terms of marketability, liquidity, reversibility, type of options, return, risk, and transaction costs.
  • Channel funds from lenders to borrowers.
  • Improve risk management for financial intermediaries.
Financial Services
  • Support borrowing, funding, lending, investing, buying and selling securities, making payments, and managing risk exposures.
  • Major categories:
    • Funds intermediation: linking savers and borrowers, leading to capital formation.
    • Payments mechanism: quick, safe, and convenient transfer of funds and settlement of transactions.
    • Provision of liquidity: enhanced through trading in securities; provided by brokers and market makers.
    • Risk management: enabling risk transfer and protection (e.g., financial insurance).
    • Financial engineering: innovative solutions for funding, investing, and risk management (e.g., restructuring, synthetic securities).
  • Producers: financial intermediaries (banks, insurance companies, mutual funds, stock exchanges).
  • Provide key services like merchant banking, leasing, hire purchase, and credit-rating.
  • Bridge the knowledge gap between investors and complex financial instruments.
  • Vital for firm creation, industrial expansion, and economic growth.
  • Financial regulators protect investors' interests by regulating market conduct and intermediaries (RBI regulates money market, SEBI regulates capital market).
  • Regulation is essential for system development and maintenance.
  • The securities market is regulated by the Department of Economic Affairs (DEA), the Department of Company Affairs (DCA), the RBI, and the SEBI, coordinated by a high-level committee.

Interaction Among Financial System Components

  • Components are interdependent and interact continuously.
  • Financial institutions mobilize savings by issuing financial instruments traded in financial markets.
  • Institutions specialize and render specialized financial services to facilitate credit allocation.
  • Financial institutions acquire, hold, and trade securities, making financial markets larger, more liquid, stable, and diversified.
  • Institutions rely on financial markets for funds.
  • Competition increases between financial markets and intermediaries.
  • New markets lead to complex securities requiring financial expertise.
  • Financial markets impact financial intermediaries; service fees are linked to market activities.
  • Liquid and broad markets make financial instruments attractive, and services may boost savings.

Functions of a Financial System

  • Links savers and investors, mobilizing and allocating savings efficiently.
  • Permits continuous technology upgrades for sustained growth.
  • Selects projects to be funded and monitors investment performance.
  • Monitors corporate performance and exerts control through the threat of hostile takeovers.
  • Provides a payment mechanism for exchanging goods and services and transfers economic resources.
  • Payment and settlement systems ensure safe, quick, and timely fund movement, contributing to operating and allocation efficiencies and overall economic growth.
  • Banks provide payments via cheques, promissory notes, credit/debit cards, and electronic means.
  • Stock market clearing and settlement are done through depositories and clearing corporations.
  • Achieves optimum risk allocation by limiting, pooling, and trading risks.
  • Aims at containing risk within acceptable limits through rules, diversification, and screening.
  • Market participants gain protection through financial insurance.
  • Risk is traded via derivatives, shifting risk from those who have it but may not want it to those who are willing to take it.
  • Provides price-related information aiding economic and financial decisions, enabling informed opinions about investments.
  • Valuation guides management on shareholder wealth maximization.
  • Minimizes asymmetric information, where one party has information the other lacks.
  • Reduces information gathering and analysis costs.
  • Offers portfolio adjustment facilities through financial markets and intermediaries.
  • Provides quick, cheap, and reliable ways to buy and sell financial assets.
  • Lowers transaction costs, benefiting savers and borrowers and incentivizing saving; promotes financial deepening and broadening.
  • Financial deepening: increase of financial assets as a percentage of Gross Domestic Product (GDP).
  • Financial depth: liquid liabilities of the financial system (currency plus demand and interest-bearing liabilities of banks and non-bank financial intermediaries) divided by the GDP. Depth=Liquid LiabilitiesGDPDepth = \frac{\text{Liquid Liabilities}}{\text{GDP}}
  • Financial broadening: increasing the number and variety of participants and instruments.

Key Elements of a Well-Functioning Financial System

  • Strong legal and regulatory environment.
  • Stable money.
  • Sound public finances and public debt management.
  • A central bank.
  • Sound banking system.
  • Information system.
  • Well-functioning securities market.
  • Strong legal systems protect investor rights.
  • Stable money serves as:
    • A medium of exchange.
    • A store of value.
    • A standard of value.
  • Sound public finance includes:
    • Setting and controlling public expenditure priorities
    • Raising adequate revenues.
  • A central bank:
    • Supervises and regulates the banking system
    • Acts as a banker to the banks
    • Banker to the government
    • Manager of public debt
    • Foreign Exchange
    • Lender of last resort
  • Monetary policy influences economic growth; an autonomous central bank fosters a sound financial system.
  • A good financial system requires a variety of banks able to withstand adverse shocks.
  • Banks perform key functions:
    • Operating clearing and payments systems.
    • Undertaking credit risk analysis.
  • Soundness depends on effective performance of these functions.
  • Information is crucial; proper disclosure and networking are essential.
  • Securities markets promote economic growth by:
    • Mobilizing and deploying funds.
    • Lowering the cost of capital.
    • Enhancing liquidity.
    • Attracting foreign investment.
  • Efficient securities markets strengthen market discipline.