The Indian Financial System &Amp; Financial Services

8/9/2019 The Indian Financial System &Amp; Financial Services

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The Financial System &

Financial Services


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Functions of the Financial System

A good financial system is a complex, well-integrated setof sub-systems of financial institutions, markets,instruments and services which facilitates the transferand allocation of funds, efficiently and effectively.

Payment system for the exchange of goods and services Pooling of resources for undertaking different types of

enterprises

Transfer of resources leading to efficient allocation ofphysical capital. This will include an efficient smooth

functioning capital market. A well developed financial system enables economicagents to pool, price and exchange risk. This includesderivatives.

It generates information which supports decentralisedand efficient decision making


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A Good Financial System

Financial markets reduce the cost of transactingincluding search costs and information costs. Searchcosts include explicit costs such as the expensesincurred on advertising when one wants to buy or sell asecurity, while implicit costs include the time and effortput in to locate a customer. Information costs refer tocosts incurred in evaluating the investment merits offinancial assets.

Often in developing economies, an Informal FinancialSystem co-exists with the Formal Financial System. Theinformal system is unorganized and unregulated, but

serves the traditional/ rural segments of the economy. Proponents of the market system argue that efficiency is

associated with the functioning of competitive financialmarkets. On the other hand, such markets are prone toinstability, with investors being exposed to market risks.


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Characteristics of Financial Markets

Large volume of transactions and the speed atwhich financial resources move from one marketto another

There is scope for arbitrage between variousmarkets and types of instruments

Financial markets are highly volatile and widespread panic/ distress selling can take place onaccount of the behaviour of a limited group of

operators Markets are usually dominated by financial

intermediaries who take investment decisions aswell as risks on behalf of depositors/ investors.


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Classification of Financial Markets

Nature ofClaims: Debt vs Equity Markets

Maturity ofClaim: Money Market vs CapitalMarket

Type ofClaim: Primary Market vs SecondaryMarket

Timing of Delivery: Cash or Spot Market vsForward or Futures Market

Organisational Structure: Exchange-traded vsOver-the-counter Market


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Financial Market Returns

Interest Rates:

An interest rate is a rate of return promised bythe borrower to the lender.

The interest rate return depends upon a varietyof factors including the unit of account, thematurity, and the default risk.

Rates of Return on Equity:

In the case of equity shares, the rates of returnare two: the cash dividend and the capitalgain/loss.


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Rates of Return on Risky Assets

Suppose you buy a share of a companys equity at a price of Rs.100. After one year you get a dividend of Rs. 5 and the share pricerise to Rs.115. Your one year return is:

Cash dividend Ending Price Beginning price

r = ----------------------- + ------------------------------------------Beginning price Beginning price

5 115 - 100

= ------ + -------------

100 100

= 5% + 15% = 20%The first component is called the dividend income component (ordividend yield) and the second component is called the capitalchange component (or capital yield). Often the two components maybe taxed differently.


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Determinants of Rates of Return

Inflation and Real Rates of Return: To make meaningful economic comparisons over time,

the prices of goods and services should be corrected forthe effects of inflation.

Similarly, a distinction can be made between nominal

and real rates of interest.The principal factors that determine the rates of return ina market economy are:

Expected productivity of capital: capital resources,comprising tangible capital and intangibles, help in

producing goods and services Degree of uncertainty characterising the productivity of

capital: in general higher the degree of uncertainty aboutthe productivity of capital, higher the risk premiumrequired by investors


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Determinants of Rates of Return

Time preferences of people: People prefercurrent consumption to future consumption.Other things being equal, the greater the

preference of the society for currentconsumption, the higher the interest rate in theeconomy and vice versa.

Degree of risk aversion: The financial system

splits the uncertain return on capital into twobroad components: a risk free return earned ondebt securities and a risky return earned onequity securities.


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Equilibrium in Financial Markets

At the equilibrium price, the supply and demand ofloanable funds are matched. This is the equilibriuminterest rate.

However, interest rates are often not determined bymarket forces.

At present, in India, the savings rate of interest ofcommercial banks, loans to weaker sections, rates ofinterest payable on small savings schemes are fixed bythe government.

The major criticism against the administered fixing of

prices is that the interest rates do not adequatelyperform the role of allocating scarce resources in aneconomy between alternative uses.

On the other hand, administered interest rates mayprotect vulnerable sections of society like the poor andthe elderly.


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Risk Return Relationship of Different

Financial Instruments


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Money Market

A money market is a market for short-term debtinstruments (maturity below one year). It is a highlyliquid market wherein securities are bought and sold inlarge denominations to reduce transaction costs. Thefunctions of a money market are:

To serve as an equilibrating force that redistributes cashbalances in accordance with the liquidity needs of theparticipants;

To form a basis for the management of liquidity andmoney in the economy by monetary authorities; and

To provide a reasonable access to the users of short-term money market for meeting the requirements atrealistic prices


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The Indian Money Market

Money Market Centres:

There are money market centres at Mumbai,Delhi and Kolkata, with Mumbai being the maincentre.

Money Market Instruments:

Treasury Bills (T-bills)

Call/ notice money market Call (overnight) andshort notice (up to 14 days)

Commercial Paper (CP)

Certificates of Deposit (CD)

Commercial Bills (CB)


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Capital Market

A capital market is a market for long-term securities(equity and debt). The purpose of the capital market isto:

Mobilize long-term savings to finance long-term

instruments; Provide risk-capital in the form of equity or quasi-equityto entrepreneurs;

Encourage broader ownership of productive assets;

Provide liquidity with a mechanism enabling the investor

to sell financial assets; Lower the costs of transactions and information; and

Improve the efficiency of capital allocation through acompetitive pricing mechanism


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Capital Market

A capital market can be further classified into

primary and secondary markets.

The primary market is meant for new issues and

the secondary market is a market whereinoutstanding issues are traded.

Basically, the primary market creates long-term

instruments for raising funds, whereas the

secondary market provides liquidity through the

marketability of these instruments.


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Rationale for Financial Intermediaries

Financial intermediaries can include commercial

banks, development financial institutions,

insurance companies, mutual funds, non-

banking finance companies, etc. They lead to: Portfolio Diversification

Lower Transaction Cost

Economics of Scale Confidentiality

Signalling


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The Financial System

Financial Institutions

Commercial Banks

Insurance Companies

Mutual Funds

Provident/ Pension Funds

NBFCs

Suppliers of Funds

Individuals

Businesses

Governments

Transfer Mechanisms

Public Issue

Private Placement

Instruments: Shares,

Loans, Securities

Demanders of Funds

Individuals

Businesses

Governments

Financial Markets

Money Market

Capital Market


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Indian Financial System

Formal Financial System InformalFinancial

System

Regulators Financial

Institutions

(Intermediaries)

Financial

Markets

Financial

Instruments

Financial

Services

Money

Lenders

Local

Bankers

Traders

Landlords

Pawn

Brokers

Ministry of

Finance

SEBI

RBI

IRDA

PensionRegulator

Banking

Institutions

Non-Banking

Institutions

Mutual Funds

Insurance Cos.

Housing Fin.

Cos.

Capital

Market

Money

Market

Term (Short,

Medium, Long

Term)

Type (Primary

& Secondary

incl. Equity,

Preference,Debt), Time

deposits, MF

units,

Insurance

policies

Depositories

Custodial

Credit rating

Factoring

Forfaiting

MerchantBanking

Leasing

Hire Purchase

Portfolio Mng.

Underwriting


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Financial Institutions (Intermediaries)

Banking Institutions Non-Banking Institutions

Scheduled

Commercial

Banks

Scheduled

Co-operative

Banks

Non-

Banking

Finance

Companies

Development

Financial Institutions

Public Sector

Private Sector

Foreign Banks

Regional Rural

Banks

All India Financial

Institutions

(IIFCL, IDFC, IFCI,

PFC, SIDBI,

NABARD, EXIM

Bank, NHB)

State Level

Institutions (SFCs,

SIDCs)


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Financial Markets

Capital Market Money Market

Equity Market Debt Market Treasury Bills

Call Money Market

C

ommercial BillsCommercial Paper

Certificates of

Deposit

Primary Market

(Public Issues, PrivatePlacement)

Secondary Market

(NSE, BSE, OTCEI,

Regional SEs)

Derivatives Market Exchange Traded

(Futures and Options)

Private Corporate

DebtPSU Bond Market

Government

Securities Market

(Primary Segment,

Secondary Segment)


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Financial Savings of Household

Sector (Gross)


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Regulatory Infrastructure

Ministry of Finance

Reserve Bank of India

Securities Exchange Board of India

Insurance Regulatory and Development

Authority

The Pension Fund Regulatory and Development

Authority


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Role of Reserve Bank of India

Provides currency and operates the clearing system forthe banks

Formulates the monetary and credit policies

Functions as the bankers bank

Supervises the operations of credit institutions

Regulates foreign exchange transactions

Moderates the fluctuations in the exchange value of therupee

Other functions: extension of the commercial bankingsystem in the rural areas; influences the allocation ofcredit; and promotes the development of new institutions


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Role of SEBI

Regulates the business in stock exchanges and anyother securities markets

Registers and regulates the capital marketintermediaries (brokers, merchant bankers, portfolio

managers, etc.) Registers and regulates the working of mutual funds

Prohibits fraudulent and unfair trade practices insecurities markets

Promotes investors education and training of

intermediaries of securities markets Prohibits insider trading in securities

Regulates substantial acquisition of shares andtakeovers of companies


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Some Trends

The Indian financial system is fairly integrated, stableand efficient.

Since the early 1990s a number of reforms measureshave been undertaken to improve the system.

Improvement in supervision of financial institutions by

RBI More freedom to commercial banks and strengthening of

their equity

Decreasing role of development financial institutions onaccount of non-access to SLR funds

Opening up the insurance sector to private players Important role being played by Foreign Institutional

Investors (FIIs) in equity market

Derivative instruments have been introduced

The Indian financial system is getting integrated with the

world financial system


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Reforms in the Financial System

Problem areas include:

Increase in fiscal deficit leading to huge issue ofgovernment debt. The Government had been trying tobring this under control with the passage of the Fiscal

Responsibility and Budget Management Act (FRBMA)which sought to eliminate revenue deficits by 2008-09.On account of the global financial meltdown, thereduction of fiscal deficit target has been postponed.

Volatility in financial markets

Low tradability of corporate bond market

Absence of yield curve

Scams in areas like stock markets, co-operative banks,etc.


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Introduction to Financial

Services


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Financial Services

Financial services are services that ensure the smoothflow of financial activities in the economy. It includingbanking, insurance, stock broking and investmentservices as well as business and professional services. Itincludes services offered by both Asset Managementcompanies.

Financial Services help to raise required funds but alsoensure their efficient deployment. To ensure an efficientmanagement of funds, services such as bill discounting,factoring of debtors, parking of short term funds in

money market, e-commerce and securitization of debtsare provided by financial service firms. Services includecredit rating, lease financing, factoring, venture capital,mutual funds, merchant banking, stock lending,depository services, housing finance, etc.


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Characteristics of Financial Services

Customer-Specific: Focused, fulfill need of the customer,with due regard to cost, liquidity and maturityconsideration

Intangibility: Quality and innovativeness of services to

build up credibility of service delivery The need to produce and deliver new and innovativefinancial services. Financial products are comparativelyeasy to replicate; so need to differentiate on servicestandards.

People centric industry and hence subjected to variabilityof performance or quality of service.

Market Dynamics: Constantly redefined and refinedtaking into consideration of various dynamics in financialservices.


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Types of Financial Services

Financial services industry could be classified under three broadcategories: Fee Based services, Fund Based services andInsurance Services

Fee Based Services :

Financial institutions operating in specialized fields earn a

substantial income by way of fees, commission, discount andbrokerage on operations. These services include Issue ManagementServices, Corporate Advisory Services, Credit Rating, Mutual Fundsbusiness, Assets Securitization, etc.

Fund Based Services :

Firms raise funds through equity, debt, and deposits and investsthese funds in securities or lends to those who are in need of capital.Such firms include Banks, Leasing and Hire Purchase Companies,Housing Finance Companies, Issuers ofCredit Cards, VentureCapital funds, Factoring, Forfaiting and Bill Discounting.

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The Indian Financial System &Amp; Financial Services

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