The Indian Financial System, 2e -- Pathak

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SystemMarkets, Institutions and

Services

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Financial System: An Introduction

1

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The Indian Financial System

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Chapter Objectives

To understand the

meaning of financial system components of the financial system functions of the financial system key elements of the financial system key elements of a well functioning financial

system bank-based and market-based financial

systems nature and role of financial institutions and

markets link between money market and capital

market link between primary market and secondary

market functions and characteristics of financial

markets.

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A set of sub systems of financial institutions, markets, instruments and services Intermediates with the flow of funds between savers and borrowers. Facilitates transfer and allocation of scarce

resources efficiently and effectively

Meaning of the Financial System

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Formal financial system – organized, institutional and regulated

Informal financial system Advantages

Low transaction costsMinimum default riskTransparency of procedures

DisadvantagesWide range of interest ratesHigher rates of interestUnregulated

Types of Financial System

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Financial Institutions

Financial Markets

Financial Instruments

Financial Services

Components of the Financial System

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Types of Financial Institutions

Banking: creators and purveyors of credit.Types

Commercial Banks Cooperative Banks Non-banking: purveyors of credit

TypesDevelopmental financial

institutions Mutual funds Insurance companies NBFCs

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Functions of Financial Institutions

Provide three transformation services

Liability, asset and size transformation

Maturity transformation

Risk transformation

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Financial Markets

Types Money Market – A market for short-term debt

instruments

Capital Market – A market for long-term equity

and debt instruments

Segments Primary Market – A market for new issues

Secondary Market – A market for trading

outstanding issues

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Link Between Primary and Secondary Capital Market

A buoyant secondary market is indispensable for the presence of a vibrant primary market.

The secondary market provides a basis for the determination of prices of new issues.

Depth of the secondary market depends on the primary market.

Bunching of new issues affects prices in the secondary market.

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Financial Instruments

Types

Primary

Secondary

Distinct Features

Marketable

Tradable

Tailor-made

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Financial Services

Major Categories Funds intermediation

Payments mechanism

Provision of liquidity

Risk management

Financial engineering

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Mobilise and allocate savingsMonitor corporate performanceProvide payment and settlement systemsOptimum allocation of risk bearing and reductionDisseminate prize related informationOffer portfolio adjustment facilityLower the cost of transactionsPromote the process of financial deepening and broadening

Functions of Financial System

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Key Elements of a Well-functioning Financial System

A strong legal and regulatory environmentStable moneySound public finances and public debt managementA central bankSound banking systemInformation systemWell-functioning securities market

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Types

Bank-based

Market-based

Financial System Designs

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Provide attractive terms to both investors and borrowersFacilitate diversificationAllow risk sharingAllow financing of new technologies

Drawbacks

Prone to instabilityExposure to market riskFree-rider problem

Market-based Financial System

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AdvantagesClose relationships with partiesProvide tailor-made contractsEfficient inter-temporal risk sharingNo free-rider problem

DrawbacksRetards innovation and growthImpedes competition

Bank-based Financial System

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Enabling economic units to exercise their time preferenceSeparation, distribution, diversification and reduction of riskEfficient payment mechanismProviding informationEnhancing liquidityProviding portfolio management services

Functions of Financial Markets