MODULE 1
Financial System: Meaning, Structure, Functions, and Constituents
Meaning of Financial System
Definition: A financial system is a network of institutions, markets, instruments, and services that facilitate
the transfer of funds between savers and borrowers.
Importance of the Financial System
1. Mobilization of Savings
Converts household and corporate savings into investments.
Banks collect savings from individuals and lend them to businesses for expansion.
2. Efficient Allocation of Resources
Funds flow to the most productive and profitable uses.
Venture Capital firms funding start-ups like BYJU'S, Zomato, etc.
3. Facilitates Economic Development
Provides capital for sectors like infrastructure, agriculture, and MSMEs.
NABARD and SIDBI offer sector-specific finance in rural and small business development.
Boosts GDP, employment, and regional development.
4. Promotes Financial Stability
A well-regulated system prevents systemic risks.
5. Liquidity Provision
Investors can easily buy/sell assets or withdraw funds.
Stock exchanges like NSE offer immediate liquidity to investors.
Encourages investment due to ease of entry/exit.
6. Facilitates Payment Mechanism
Enables smooth and secure transfer of money.
Promotes digital economy and financial inclusion.
7. Supports Policy Implementation
Helps governments manage liquidity and inflation.
RBI uses repo/reverse repo operations to control money supply.
8. Encourages Foreign Investment
A stable and transparent system attracts global capital.
Boosts forex reserves, capital inflows, and rupee strength.
Structure of the Financial System
Components:
1. Financial Institutions
Banking: Commercial Banks, Cooperative Banks
Non-Banking: LIC, Mutual Funds, NBFCs
2. Financial Markets
Capital Market: Stock and Bond Markets
Money Market: Treasury Bills, Call Money
3. Financial Instruments
Equity Shares, Bonds, Debentures, Derivatives
4. Financial Services
Investment Banking, Insurance, Credit Rating
Participants in a financial system
1. Financial Institutions
These are intermediaries that provide financial services and facilitate transactions:
Banks (Commercial, Investment, Central)
Insurance Companies
Mutual Funds
Pension Funds
Non-Banking Financial Companies (NBFCs)
Microfinance Institutions
2. Financial Markets
These platforms allow buying and selling of financial assets:
Capital Markets (Stock markets and bond markets)
Money Markets (Short-term borrowing and lending)
Derivatives Markets (Futures, options)
Foreign Exchange Markets (Forex)
3. Financial Intermediaries
Entities that bridge the gap between savers and borrowers:
Brokers
Dealers
Underwriters
Credit Rating Agencies
4. Regulatory Bodies
Ensure the smooth and legal functioning of the financial system:
Central Banks (e.g., Reserve Bank of India, Federal Reserve)
Securities and Exchange Commissions (e.g., SEBI in India, SEC in the US)
Insurance Regulatory Authorities (e.g., IRDAI in India)
Pension Regulators
5. Government and Quasi-Government Institutions
Influence the financial system through fiscal and monetary policies:
Ministry of Finance
Public Sector Financial Institutions
Development Banks (e.g., NABARD, SIDBI)
6. Corporations and Businesses
7. Investors and Lenders
8. Borrowers
Entities that need capital:
Individuals (e.g., consumers, students)
Businesses
Governments (issue bonds and securities)
9. Consumers
10. Technology Providers
FINANCIAL MARKETS
A financial market is a place (physical or digital) where people buy and sell financial assets like shares,
bonds, currencies, and more.
Functions of Financial Markets:
1. Helps in Raising Capital
Companies can raise money from the public by issuing shares or bonds.
2. Provides Liquidity
Investors can easily buy and sell assets (like stocks) and turn them into cash.
3. Price Discovery
Determines the price of financial assets based on demand and supply.
4. Reduces Transaction Costs
Buyers and sellers are brought together, reducing the cost of finding each other.
5. Facilitates Savings and Investment
Encourages people to save money and invest it in productive opportunities.
6. Transfers Risk
Financial instruments like derivatives help shift risk from one party to another.
Types of Financial Markets:
1. Capital Market
For long-term investments (more than 1 year)
Includes:Stock Market – Buying/selling shares
Bond Market – Buying/selling government and corporate bonds
2. Money Market
For short-term funds (less than 1 year)
Instruments: Treasury bills, commercial papers, certificates of deposit
3. Foreign Exchange Market (Forex)
Where currencies of different countries are bought and sold.
4. Derivatives Market
For trading financial contracts like futures and options (based on the value of assets like stocks,
commodities, etc.)
5. Commodity Market
For buying and selling physical goods like gold, silver, oil, wheat, etc.
MONEY MARKET
According to Nadler and Shipman, "A money market is a mechanical device through which short term
funds are loaned and borrowed through which a large part of the financial transactions of a particular
country or world are degraded. A money market is distinct from but supplementary to the commercial
banking system."
According to the McGraw Hill Dictionary of Modern Economics, "money market is the term designed to
include the financial institutions which handle the purchase, sale, and transfers of short-term credit
instruments. The money market includes the entire machinery for the channelizing of short-term funds.
Concerned primarily with small business needs for working capital, individual's borrowings, and
government short term obligations, it differs from the long term or capital market which devotes its
attention to dealings in bonds, corporate stock and mortgage credit."
According to the Reserve Bank of India, "money market is the centre for dealing , mainly of short-term
character, in money assets; it meets the short-term requirements of borrowings and provides liquidity or
cash to the lenders. It is the place where short term surplus investible funds at the disposal of financial and
other institutions and individuals are bid by borrowers' agents comprising institutions and individuals and
also the government itself."
Features of money markets
1. Liquidity: Since these instruments are highly liquid, they allow easy access to funds for investors. They
can also be bought and sold quite easily without affecting their market value.
2. Safety: These financial instruments are generally issued by trustworthy entities like the government or
huge businesses with a solid reputation, which in turn makes them low risk. Hence, they are considered to
be relatively safer than other short-term investment options that help with capital preservation.
3. Stable returns: Money market instruments are known for their stability and ability to preserve an
investor's capital. They offer periodic and predictable returns or provide discounts on their maturity,
making for a decent investment return.
4. Diversification: They offer an investor a great opportunity to diversify their portfolio. Investors can
park their money in different money market instruments with varied rates of interest and maturity
horizons to spread their risk and minimise exposure to any one particular asset or financial instrument.
5. Short-term financing: Money markets offer different entities like governments, corporations, and
institutions a safe and convenient way to meet any short-term financial obligation and manage their
liquidity.
STRUCTURE OF MONEY MARKET
[Link] Money Market: This sector of the money market in India is characterized by registration,
approval, and license from market [Link] is called organized because it is systematically coordinated
by the RBI and other market [Link] participants in the Organized Money Market in India
include – the RBI, Banks, NBFCs, Mutual Funds, Insurance Companies, etc.
[Link] Money Market: This sector of the money market in India refers to the one that is not
registered and not regulated. It is called unorganized because it is not systematically coordinated by the
RBI or any other market regulator. Major participants in the Unorganized Money Market in India
include – Local Moneylenders, Chit Funds, etc.
INSTRUMENTS OF MONEY MARKET
[Link] Money or Money at Call
Call Money refers to inter-bank borrowing and lending for a very short period, typically overnight to
upto 14 days.
The Call Money or Money at Call enables banks and financial institutions to manage their short-term
liquidity requirements.
The rate at which money is borrowed in these markets is called the Call Money Rate.
The Call Money Rate keeps changing on an hourly basis, depending on the demand and supply.
Call Money Market has 2 segments:
a. Call Market or Overnight Market: It refers to the market for borrowing and lending of money between
banks for 1 day.
b. Short Notice Market: It refers to the market for borrowing and lending of money between
banks for upto 14 days.
2. TREASURY BILLS
Treasury Bills or T-Bills refer to short-term securities issued by the RBI on behalf of the Central
Government.
They act as short-term fundraising tools for the government.
Treasury Bills (T-Bills) are one of the two types of Government Securities (G-Secs).
One other type of Government Securities (G-Secs) is Government Bonds, which have a maturity
period of more than 1 year and hence are Capital Market instruments.
Features of Treasury Bills (T-Bills)
Treasury bills are issued at a discount to the original value and the buyer gets the original value upon
maturity.
For example, a Rs 100 treasury bill can be availed of at Rs 95, but the buyer is paid Rs 100 on the
maturity date. This is called redemption at par or face value.
Thus, they are non-interest bearing i.e. Zero coupon or zero interest, and hence are also called zero
coupon bonds.
Being backed by the Government, these bills are considered risk-free and are highly liquid.
These bills are issued only by the Central Government (through the RBI).
The State Governments do not issue T-Bills.
Instead of direct selling, T-Bills are auctioned in the market, wherein each buyers submit their bids
and the bill is sold to the buyer willing to pay the highest price.
The option of bidding ensures the highest revenue for the government as well as transparency in the
issuing process.
T-Bills are available for a minimum amount of ₹ 25,000 or in multiples of ₹ 25,000.
As of now, there are 3 types of T-Bills auctioned by the RBI:
91-day T-Bills – Have a maturity period of 91 days.
182-day T-Bills – Have a maturity period of 182 days.
364-day T-Bills – Have a maturity period of 364 days.
T-Bills can be used by the Banks for: Keeping as part of their SLR requirements. Providing as
collateral to the RBI for getting loans under Repo.
3. Cash Management Bills (CMBs)
Similar to T-Bills, CMBs are also short-term securities sold by the RBI on behalf of the Central
Government, but with a maturity period of less than 91 days.
It is also aimed at meeting the short-term cash flow mismatches of the Government of India.
Similar to T-Bills, CMBs are also issued at a discount to the face value through auctions by the RBI.
Banks are allowed to keep CMBs to meet their SLR requirements.
4. Commercial Paper (CP)
Commercial Paper is a type of unsecured, short-term debt instrument issued by large Corporations,
Primary Dealers, and Financial Institutions (FIs).
The eligible institutions may issue Commercial Papers (CPs) to finance their short-term needs, such as
inventory management, meeting payroll expenses, funding new projects, etc.
A Commercial Paper is issued as an unsecured promissory note and is placed privately.
They should be issued in multiples of ₹5 lakh, with a minimum amount of ₹5 lakh.
Their maturity period is a minimum of 7 days and a maximum of up to 1 year.
5. Certificate of Deposit
A Certificate of Deposit or CD is a fixed-income financial tool that is governed by the Reserve Bank of
India and is issued in a dematerialized form. It is a type of agreement made between the depositors and
the banks, wherein the bank pays an interest on your investment. Certificate of Deposit is a short-term
investment that comes with fixed investment amounts and maturity tenure ranging between 1-3 years.
Features of Certificate of Deposit
Certificate of deposit in India can be issued for a minimum deposit of Rs. 1 lakh or in subsequent
multiples of it.
Certificates of deposit are issued by the Scheduled Commercial Banks (SCBs) and All-India Financial
Institutions. The Cooperative Banks and the Regional Rural Banks(RRBs) are not eligible for issuing
a CD.
There is a term period of 3 months to 1 year for CDs that are issued by SCBs, whereas the term
period ranges from 1 year to 3 years for CDs issued by financial institutions.
CDs in dematerialised forms can be transferred through endorsement or delivery, similar to
dematerialised securities.
There is no lock-in period for a certificate of deposit.
It is fully taxable under the Income Tax Act.
[Link] agreements
Short-term loans—normally for less than one week and frequently for one day—arranged by selling
securities to an investor with an agreement to repurchase them at a fixed price on a fixed date.
[Link] market mutual funds
short-term investment debt, operated by professional institutions. Money market mutual funds are an
investment fund where a number of investors invest their money in mutual fund institutions, and they
diversify the funds in various investments.
Functions of the money market
1. Providing funds: The money market offers short-term loans at lower interest rates, enabling private and
public institutions to meet their capital needs. Companies use instruments like commercial paper, while the
government raises funds through treasury bills to finance projects and maintain cash flow.
2. Guiding central bank policies: The money market helps the central bank implement monetary policies
by monitoring short-term interest rates, providing insights into the banking sector, and guiding policy
decisions related to interest rates and liquidity.
3. Government financing: The government utilizes the money market to raise short-term funds through
treasury bills for public welfare projects and infrastructure development. This method of borrowing
reduces inflationary pressures compared to direct borrowing from the central bank.
4. Financial mobility: The money market enables easy transfer of funds between sectors, promoting
flexibility and development within the economy by ensuring that funds are available where they are most
needed.
5. Promoting liquidity and safety: The money market provides liquidity and safety by offering short-term
investment instruments that are easily convertible to cash. These instruments, issued by creditworthy
entities, are considered low-risk investments.
6. Economising cash use: By dealing in near-money assets rather than physical cash, the money market
facilitates secure and efficient transfers of funds, minimizing the need for cash and supporting the smooth
operation of businesses.
Role of Central Bank in the Money Market
The Central Bank of a country (RBI in India) is the regulator of the money market. However, its role is
not confined to that of a regulator only; it is also a player or a participant in the money market. In
particular, the Central Bank
a) Sets the rules in the money market. For example, it lays down the eligibility conditions for the
participants (in India, RBI stipulates who can issue a Commercial Paper or who can borrow/lend in the
Call Money Market etc.). The Central Bank also lays down the transaction principles in many markets,
like, say, in the Call Money market, the Treasury Bill market or the repo market in case
of India.
b) Acts as a referee in the money market. In other words, it supervises whether all guidelines are being
properly followed or not. If not, it has the power to impose penalty on a defaulting participant.
c) Acts a player in the money market. For example, it issues Treasury Bills in the market on behalf of the
Government, it issues repos and reverse repos etc. thereby controlling the liquidity in the economy in a
direct manner.
d) Provides interest rate signals. For example, the fixing of the repo rate and the reverse repo rate has a
direct impact on the interest rate in the call money or other markets.
e) Develops the money market. One of the important tasks of the Central Bank is to develop the money
market. By development, we mean
(i) Adding depth (increasing the supply of and demand for various money market
instruments) and width (increasing the types of money market instruments) in the market,
(ii)Improving the transaction mechanism, like, say, building a robust electronic platform for
e-transaction of instruments,
(iii) Make the market more transparent,
(iv)Make the market more accessible to the public, etc.
Indian Money Market – An Overview
The Indian money market can be divided into two parts- an organised money market and an unorganised
money market. This dualism is present in all Indian markets.
CAPITAL MARKET
A capital market is a financial marketplace where buyers and sellers trade long-term financial instruments,
like stocks and bonds, to raise or invest capital. It connects those needing capital (businesses, governments)
with those having capital (investors).
FEATURES OF CAPITAL MARKET
Long term Financial Assets
Capital Formation
Liquidity
Price Discovery
Risk Management
Economic Growth
Risk Diversification
TYPES OF CAPITAL MARKET
[Link] Markets
Primary capital markets are where companies first sell new stock or bonds publicly. Also known as the
'New Issues Market', it is a place where businesses and governments seek out new financing. The new
money is converted into debt or shares of the company.
In the primary market, pricing of shares refers to how companies decide the price at which they will offer
their shares to the public for the first time, usually during an Initial Public Offering (IPO) or a Follow-on
Public Offer (FPO).There are two main methods used in India (and in most markets):
1. Fixed Price Method
The company pre-determines a fixed price for each share. This price is mentioned in the offer document.
Investors know the price before applying. Payment is made along with the application. If shares are
oversubscribed, allotment is done proportionately, and the extra money is refunded. Example: If the fixed
price is ₹120 and you apply for 100 shares, you pay ₹12,000 at the time of application.
2. Book Building Method
The company announces a price band (e.g., ₹100–₹120). Investors bid within this [Link] demand at
various price levels is recorded in an electronic book. After the bidding closes, the final issue price (called
the cut-off price) is decided based on demand. Institutional investors, high-net-worth individuals (HNIs),
and retail investors may have separate quotas.
Example:
Price band = ₹100–₹120
If most investors bid at ₹115, the cut-off price might be set at ₹115.
[Link] Markets
Investors trade old debt or stocks on the secondary capital market. It differs from the primary market
because the debt has already been issued here. Investors trade stock in the secondary capital markets
through exchanges such as the Bombay Stock Exchange, the Calcutta Stock Exchange, and the New York
Stock Exchange. A stock exchange also allows people to sell the old stock if they no longer want it, which
results in the 'liquidation' of these stocks. Thus, the seller now has cash rather than an asset.
Types of Secondary Market
There are two types of secondary markets; stock markets and over-the-counter markets.
[Link] markets
The stock market, sometimes known as the equity market, is a regulated marketplace for purchasing and
selling publicly listed business stocks and derivatives. It is based on the idea that investors can swap stock
shares to optimise their returns.
[Link]-the-counter markets
The over-the-counter (OTC) market is a global network of decentralised financial institutions and dealers
that trade securities that are not listed on a stock exchange. OTC trades often involve smaller firms or
securities that do not match the main exchanges’ listing standards.
The primary distinctions between the stock market and the OTC market are market size and liquidity,
investment liquidity, and trading costs. The stock exchange is far larger and more liquid than the OTC
market. It is also more regulated, which means that while trading, investors may anticipate better pricing
and more dependable information. The OTC market is less regulated and more volatile, making it ideal for
more aggressive traders
Examples of Secondary Market
Stock exchanges and markets are examples of secondary markets.
BSE
The Bombay Stock Market (BSE) is Asia’s oldest stock exchange, and it is based in Mumbai, India. It is
the world’s tenth-largest stock exchange by market capitalization and the largest in India in terms of daily
turnover and transaction volume. It permits the trading of stocks and other financial goods such as equity
derivatives, mutual funds, and bonds between buyers and sellers.
NSE
The National Stock Exchange of India (NSE) is India’s largest stock exchange and the world’s second-
largest by market value. Its headquarters are in Mumbai, India, and it has a market capitalization of more
than US$2.27 trillion. It provides a wide range of products, including equities derivatives, currency
derivatives, mutual funds, ETFs, bonds, and other financial instruments.
NASDAQ
The NASDAQ is a stock exchange in New York City, New York, USA. It is the world’s second-biggest
exchange by market capitalisation and the world’s largest electronic screen-based stock exchange. It
includes almost 3,000 organisations from a variety of industries, including technology, biotechnology,
retail, financial services, transportation, and others.
NYSE
The New York Stock Exchange (NYSE) is a stock exchange in New York City, New York, United States.
It is the largest stock exchange in the world in terms of market value and the most varied in terms of listed
firms. It contains nearly 2,400 listed firms from a variety of industries including banking, technology,
retail, energy, and others. The NYSE also supports trading in stocks, stock options, and fixed-income
instruments.
Different Instruments in the Secondary Market
The aftermarket trades on different instruments can be categorised into three types,
1. Fixed Income Instrument: These types of instruments are investments that generate fixed income or
regular income. For instance, the monthly interest and on maturity the principal amount. Debentures and
bonds are also a form of fixed-income instruments.
2. Variable Income Instrument: As the name suggests variable, means not fixed. These investments do not
guarantee a fixed income, rather the market decides the variable returns. These instruments are highly
risky but can generate high returns. Examples include equity and derivatives investment.
3. Hybrid Instrument: Some instruments which provide both fixed and variable returns are termed hybrid
instruments. If an investor invests in these forms of instrumentation, then he/she might generate either
high or low returns but a fixed amount will always generate. An example of the hybrid instrument is the
convertible debenture which is primarily a debt security but can be converted into equity shares after some
time.
GLOBAL FINANCIAL MARKETS
Global financial market means the system where money and financial products are exchanged between
people and businesses from different countries.
1. International Trade of Money
2. Currencies are Traded
3. Shares and Bonds from Around the World
4. Cross-Border Investment
Types of Global Financial Markets
[Link] Exchange Market
traded-Currencies,
USD to INR
[Link] Stock Market
Shares of international companies,
Apple, Reliance, TCS, Tesla
[Link] Bond Market
Bonds issued by governments/companies,
World Bank bonds, Eurobonds
[Link] Market
Gold, Oil, Silver, Wheat, etc.
Crude oil prices on NYMEX
[Link] Market
Contracts like futures/options
Hedging oil price changes
BENEFITS OF GLOBAL MARKETS
Increased Market Potential
Economies of scale
Diversification of Risks
Reaching wider Audience
Helps countries borrow or invest easily
Global business and trade
RISKS OF GLOBAL MARKETS
Currency value changes
Political or war related issues.
Economic crisis in one country can affect others