Module - 1: Introduction to Financial System

Structure

1.1 : Introduction ................................................................................................................. 1

1.2 : Formal and Informal Financial Sectors ....................................................................... 1
1.3 : The Indian Financial System ....................................................................................... 2
1.4 : COMPONENTS OF THE FORMAL FINANCIAL SYSTEM .................................. 2
1.5 : Functions of a Financial System ................................................................................. 4
1.6 : Functions of Foreign Exchange Market .................................................................... 14
1.7 : Features of Foreign Exchange Market ...................................................................... 15
1.8 : Suggested Readings / Reference Books .................................................................... 16

Learning Objectives

1.1 : Introduction

A financial system plays a vital role in the economic growth of a country. It intermediates
between the flow of funds belonging to those who save a part of their income and those who
invest in productive assets. It mobilizes and usefully allocates scarce resources of a country.
A financial system is a complex, well-integrated set of sub-systems of financial institutions,
markets, instruments, and services which facilitates the transfer and allocation of funds,
efficiently and effectively.

1.2 : Formal and Informal Financial Sectors

The financial systems of most developing countries are characterized by coexistence and
cooperation between the formal and informal financial sectors. This coexistence of these two
sectors is commonly referred to as ‘financial dualism.’ The formal financial sector is
characterized by the presence of an organized, institutional, and regulated system which
caters to the financial needs of the modern spheres of economy; the informal financial sector

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is an unorganized, non-institutional, and non-regulated system dealing with the traditional
and rural spheres of the economy.

The informal financial sector has emerged as a result of the intrinsic dualism of economic and
social structures in developing countries, and financial repression which inhibits the certain
deprived sections of society from accessing funds. The informal system is characterized by
flexibility of operations and interface relationships between the creditor and the debtor. The
advantages are: low transaction costs, minimal default risk, and transparency of procedures.
Due to these advantages, a wide range and higher rates of interest prevail in the informal
sector.
An interpenetration is found between the formal and informal systems in terms of operations,
participants, and nature of activities which, in turn, have led to their coexistence. A high
priority should be accorded to the development of an efficient formal financial system as it
can offer lower intermediation costs and services to a wide base of savers and entrepreneurs.

1.3 : The Indian Financial System

The Indian financial system can also be broadly classified into the formal (organized) finan-
cial system and the informal (unorganized) financial system. The formal financial system
comes under the purview of 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 consists of:
• Individual moneylenders such as neighbours, relatives, landlords, traders, and storeowners.
• Groups of persons operating as ‘funds’ or ‘associations.’ These groups function under a
system of their own rules and use names such as ‘fixed fund,’ ‘association,’ and ‘saving
club.’
• Partnership firms consisting of local brokers, pawnbrokers, and non-bank financial
intermediaries such as finance, investment, and chit-fund companies.
In India, the spread of banking in rural areas has helped in enlarging the scope of the formal
financial system.

1.4 : COMPONENTS OF THE FORMAL FINANCIAL SYSTEM

The formal financial system consists of four segments or components. These are: financial
institutions, financial markets, financial instruments, and financial services

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1.5 : Functions of a Financial System
• Mobilize and allocate savings - One of the important functions of a financial system is to
link the savers and investors and, thereby, help in mobilizing and allocating the savings
efficiently and effectively. By acting as an efficient conduit for allocation of resources, it
permits continuous upgradation of technologies for promoting growth on a sustained basis.

• Monitor corporate performance - A financial system not only helps in selecting projects to
be funded but also inspires the operators to monitor the performance of the investment.
Financial markets and institutions help to monitor corporate performance and exert corporate
control through the threat of hostile takeovers for underperforming firms.

• Provide payment and settlement systems - It provides a payment mechanism for the
exchange of goods and services and transfers economic resources through time and across
geographic regions and industries. Payment and settlement systems play an important role to
ensure that funds move safely, quickly, and in a timely manner. An efficient payment and
settlement system contributes to the operating and allocation efficiencies of the financial
system and thus, overall economic growth. Payment and settlement systems serve an
important role in the economy as the main arteries of the financial sector. Banks provide this
mechanism by offering a means of payment facility based upon cheques, promissory notes,
credit and debit cards. This payment mecha- nism is now increasingly through electronic
means. The clearing and settlements mechanism of the stock markets is done through
depositories and clearing corporations.

• Optimum allocation of risk-bearing and reduction - One of the most important functions of
a financial system is to achieve optimum allocation of risk bearing. It limits, pools, and trades
the risks involved in mobilizing savings and allocating credit. An efficient financial system
aims at containing risk within acceptable limits. It reduces risk by laying down rules
governing the operation of the system. Risk reduction is achieved by holding diversified
portfolios and screening of borrowers. Market participants gain protection from unexpected
losses by buying financial insurance services. Risk is traded in the financial markets through
financial instruments such as derivatives. Derivatives are risk shifting devices, they shift risk
from those who have it but may not want it to those who are willing to take it.

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• Disseminate price- related information - A financial system also makes available price-
related information which is a valuable assistance to those who need to take economic and
financial decisions. Financial markets disseminate information for enabling participants to
develop an informed opinion about investment, disinvestment, reinvestment, or holding a
particular asset. This information dissemination enables a quick valuation of financial assets.
Moreover, by influencing the market price of a firm’s debt and equity instruments, this
process of valua- tion guides the management as to whether their actions are consistent with
the objective of shareholder wealth maximization. In addition, a financial system also
minimises situations where the information is asymmetric and likely to affect motivations
among operators when one party has the information and the other party does not. It also
reduces the cost of gathering and analysing information to assist operators in taking decisions
carefully.

• Offer portfolio adjustment facility - A financial system also offers portfolio adjustment
facilities. These are provided by financial markets and financial intermediaries such as banks
and mutual funds. Portfolio adjustment facilities include services of providing a quick, cheap
and reliable way of buying and selling a wide variety of financial assets.

• Lower the cost of transactions - A financial system helps in the creation of a financial
structure that lowers the cost of transactions. This has a beneficial influence on the rate of
return to savers. It also reduces the cost of borrowing. Thus, the system generates an impulse
among the people to save more.

• Promote the process of financial deepening and broadening - A well-functioning financial

system helps in promoting the process of financial deepening and broad- ening. Financial
deepening refers to an increase of financial assets as a percentage of the Gross Domestic
Product (GDP). Financial depth is an important measure of financial system development as
it measures the size of the financial intermediary sector. Depth equals the liquid liabilities of
the financial system (currency plus demand and interest-bearing liabilities of banks and non-
bank financial intermediaries divided by the GDP). Financial broadening refers to building an
increasing number and variety of par- ticipants and instruments.

Financial Concepts

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An understanding of the financial system requires an understanding of the following financial
concepts:
Financial assets
Financial intermediaries
Financial markets
Financial Rate of return
Financial Instruments

Financial assets can be defined as an investment asset whose value is derived from a
contractual claim of what they represent. These are liquid assets as the economic resources or
ownership can be converted into matter, such as cash. These are also referred to as financial
instruments or securities. They are widely used to finance real estate and ownership
of tangible assets.

These are legal claims, and these legal contracts are subject to future cash at a
predefined maturity value and predetermined time frame.

Types of Financial Assets

These all can be classified into different categories according to the cash flow features
associated with them.

Certificate of Deposit (CD)

This financial asset is an agreement between an investor (here, company) and a bank
institution. The customer (Company) keeps a set amount of money deposited in the bank for
the agreed term in exchange for a guaranteed interest rate.

Bonds

This financial asset is usually a debt instrument sold by companies or the government to raise
funds for short-term projects. A bond is a legal document that states the money the investor

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has lent the borrower, the amount it needs to be paid back (plus interest), and the bond’s
maturity date.

Stocks

Stocks do not have any maturity date. Investing in stocks of a company means participating
in the company’s ownership and sharing its profits and losses. Stocks belong
to shareholders until and unless they sell them.

Cash or Cash Equivalent

This type of financial asset is the cash or equivalent reserved with the organization.

Bank Deposits

These are the cash reserve of the organization with Banks in saving and checking accounts.

Loans & Receivables

Loans and Receivables are those assets with fixed or determinable payments. For banks,
loans are such assets as they sell them to other parties as their business.

Derivatives

Derivatives are financial assets whose value is derived from other underlying assets. These
are contracts.

All the above assets are liquid assets as they can be converted into their respective values as
per the contractual claims of what they represent. They do not necessarily have inherent
physical worth like land, property, commodities, etc.

Financial Intermediaries

Financial institutions (intermediaries) are business organizations serving as a link between

savers and investors and so help in the credit-allocation process. Good financial institutions
are vital to the functioning of an economy. If finance were to be described as the circulatory
system of the economy, financial institutions are its brain. They make decisions that tell

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scarce capital where to go and ensure that it is used most efficiently. It has been confirmed by
research that countries with developed financial institutions grow faster and countries with
weak ones are more likely to undergo financial crises.

Lenders and borrowers differ in regard to terms of risk, return, and terms of maturity.
Financial institutions assist in resolving this conflict between lenders and borrowers by
offering claims against themselves and, in turn, acquiring claims on the borrowers. The
former claims are referred to as indirect (secondary) securities and the latter as direct
(primary) securities.

Financial institutions provide three transformation services:

Financial Institutions Provide Three Transformation Services

• Liability, asset, and size transformation - Liability, asset, and size transformation consisting
of mobilization of funds, and their allocation by providing large loans on the basis of
numerous small deposits.

• Maturity transformation - Maturity transformation by offering the savers tailor-made short-

term claims or liquid deposits and so offering borrowers long-term loans matching the cash-
flows generated by their investment.

• Risk transformation - Risk transformation by transforming and reducing the risk involved in
direct lending by acquiring diversified portfolios.

Through these services, financial institutions are able to tap savings that are unlikely to be
acceptable otherwise. Moreover, by facilitating the availability of finance, financial
institutions enable the consumer to spend in anticipation of income and the entrepreneur to
acquire physical capital.

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The role of financial institutions has undergone a tremendous transformation in the 1990s.
Besides providing direct loans, many financial institutions have diversified themselves into
areas of financial ser- vices such as merchant banking, underwriting and issuing guarantees.

Financial Markets

Financial markets are an important component of the financial system. They are a mechanism
for the exchange trading of financial products under a policy framework. The participants in
the financial mar- kets are the borrowers (issuers of securities), lenders (buyers of securities),
and financial intermediaries. Financial markets comprise two distinct types of markets:

Types

 • Money Market—a market for short-term debt instruments

 • Capital Market—a market for long-term equity and debt instruments

Money Market A money market is a market for short-term debt instruments (maturity below
one year). It is a highly liquid market wherein securities are bought and sold in large
denominations to reduce transaction costs. Call money market, certificates of deposit,
commercial paper, and treasury bills are the major instruments/segments of the money
market.

Capital Market A capital market is a market for long-term securities (equity and debt). The
purpose of capital market is to

• mobilize long-term savings to finance long-term investments;

• provide risk capital in the form of equity or quasi-equity to 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 a competitive pricing mechanism.

Characteristics of Financial Markets

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  Financial markets are characterized by a large volume of transactions and the speed
with which financial resources move from one market to another.
 There are various segments of financial markets such as stock markets, bond
markets—primary and secondary segments, where savers themselves decide when
and where they should invest money.
 There is scope for instant arbitrage among various markets and types of instruments.
 Financial markets are highly volatile and susceptible to panic and distress selling as
the behaviour of a limited group of operators can get generalized.
 Markets are dominated by financial intermediaries who take investment decisions as
well as risks on behalf of their depositors.
 Negative externalities are associated with financial markets. A failure in any one
segment of these markets may affect other segments, including non-financial markets.
 Domestic financial markets are getting integrated with worldwide financial markets.
The failure and vulnerability in a particular domestic market can have international
‘ramifications.’ Similarly, problems in external markets can affect the functioning of
domestic markets.

In view of the above characteristics, financial markets need to be closely monitored and
supervised.

Functions of Financial Markets

The cost of acquiring information and making transactions creates incentives for the
emergence of financial markets and institutions. Different types and combinations of
information and transaction costs motivate distinct financial contracts, instruments and
institutions.

Financial markets perform various functions such as

 Enabling economic units to exercise their time preference;

 Separation, distribution, diversification, and reduction of risk;
 Efficient payment mechanism;

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  Providing information about companies. This spurs investors to make inquiries
themselves and keep track of the companies’ activities with a view to trading in their
stock efficiently;
 Transmutation or transformation of financial claims to suit the preferences of both
savers and Borrowers;
 Enhancing liquidity of financial claims through trading in securities; and
 Providing portfolio management services.

A variety of services are provided by financial markets as they can alter the rate of economic
growth by altering the quality of these services.

Financial Rate of Return

A rate of return (RoR) can be applied to any investment vehicle, from real estate to bonds,
stocks, and fine art. The RoR works with any asset provided the asset is purchased at one
point in time and produces cash flow at some point in the future. Investments are assessed
based, in part, on past rates of return, which can be compared against assets of the same type
to determine which investments are the most attractive.

Financial Instruments

A financial instrument is a claim against a person or an institution for payment, at a future

date, of a sum of money and/or a periodic payment in the form of interest or dividend. The
term ‘and/or’ implies that either of the payments will be sufficient but both of them may be
promised. Financial instruments represent paper wealth shares, debentures, like bonds and
notes. Many financial instruments are marketable as they are denominated in small amounts
and traded in organized markets. This distinct feature of financial instruments has enabled
people to hold a portfolio of different financial assets which, in turn, helps in reducing risk.

Different types of financial instruments can be designed to suit the risk and return preferences
of different classes of investors.

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Savings and investments are linked through a wide variety of complex financial instruments
known as ‘securities.’ Securities are defined in the Securities Contracts Regulation Act
(SCRA), 1956 as includ- ing shares, scrips, stocks, bonds, debentures, debenture stocks or
other marketable securities of a similar nature or of any incorporated company or body
corporate, government securities, derivatives of securi- ties, units of collective investment
scheme, security receipts, interest and rights in securities, or any other instruments so
declared by the central government.

Financial securities are financial instruments that are negotiable and tradeable. Financial
securities may be primary or secondary securities. Primary securities are also termed as direct
securities as they are directly issued by the ultimate borrowers of funds to the ultimate savers.
Examples of primary or direct securities include equity shares and debentures. Secondary
securities are also referred to as indirect secu- rities, as they are issued by the financial
intermediaries to the ultimate savers. Bank deposits, mutual fund units, and insurance policies
are secondary securities.

Financial instruments differ in terms of marketability, liquidity, reversibility, type of options,

return, risk, and transaction costs. Financial instruments help financial markets and financial
inter- mediaries to perform the important role of channelizing funds from lenders to
borrowers. Availabil- ity of different varieties of financial instruments helps financial
intermediaries to improve their own risk management.

The Foreign Exchange Market

Every country has their respective currencies which they use in their trade and businesses, but
what about in the foreign market? With the lack of versatility of the currencies, they become
a hurdle in world trade. To solve this problem, the Foreign Exchange Market was introduced.
This is a type of marketplace that will fix the exchange rate for the currencies.

Without the foreign exchange market, the world economy would suffer terribly. Thus, it
becomes important for us to consider this topic as a prior study. In this context, we will

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define the foreign exchange market, discuss the types, features, and participants in the same
market.

Define Foreign Exchange Market

The foreign exchange market is over a counter (OTC) global marketplace that determines the
exchange rate for currencies around the world. This foreign exchange market is also known
as Forex, FX, or even the currency market. The participants engaged in this market are able
to buy, sell, exchange, and speculate on the currencies.

These foreign exchange markets are consisting of banks, forex dealers, commercial
companies, central banks, investment management firms, hedge funds, retail forex dealers,
and investors. In our prevailing section, we will widen our discussion on the ‘Foreign
Exchange Market’.

Types of Foreign Exchange Market

The Foreign Exchange Market has its own varieties. We will know about the types of these
markets in the section below:

The Major Foreign Exchange Markets −

 Spot Markets
 Forward Markets
 Future Markets
 Option Markets
 Swaps Markets

Let us discuss these markets briefly:

 Spot Market

In this market, the quickest transaction of currency occurs. This foreign exchange market
provides immediate payment to the buyers and the sellers as per the current exchange rate.

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The spot market accounts for almost one-third of all the currency exchange, and trades which
usually take one or two days to settle the transactions.

 Forward Market

In the forward market, there are two parties which can be either two companies, two
individuals, or government nodal agencies. In this type of market, there is an agreement to do
a trade at some future date, at a defined price and quantity.

 Future Markets

The future markets come with solutions to a number of problems that are being encountered
in the forward markets. Future markets work on similar lines and basic philosophy as the
forward markets.

 Option Market

An option is a contract that allows (but is not as such required) an investor to buy or sell an
instrument that is underlying like a security, ETF, or even index at a determined price over a
definite period of time. Buying and selling ‘options’ are done in this type of market.

 Swap Market

A swap is a type of derivative contract through which two parties exchange the cash flows or
the liabilities from two different financial instruments. Most swaps involve these cash flows
based on a principal amount.

1.6 : Functions of Foreign Exchange Market

The various functions of the Foreign Exchange Market are as follows:

 Transfer Function: The basic and the most obvious function of the foreign exchange
market is to transfer the funds or the foreign currencies from one country to another
for settling their payments. The market basically converts one’s currency to another.
 Credit Function: The FOREX provides short-term credit to the importers in order to
facilitate the smooth flow of goods and services from various countries. The importer
can use his own credit to finance foreign purchases.
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  Hedging Function: The third function of a foreign exchange market is to hedge the
foreign exchange risks. The parties in the foreign exchange are often afraid of the
fluctuations in the exchange rates, which means the price of one currency in terms of
another currency. This might result in a gain or loss to the party concerned.

1.7 : Features of Foreign Exchange Market

This kind of exchange market does have characteristics of its own, which are required to be
identified. The features of the Foreign Exchange Market are as follows:

1. High Liquidity

The foreign exchange market is the most easily liquefiable financial market in the whole
world. This involves the trading of various currencies worldwide. The traders in this market
are free to buy or sell the currencies anytime as per their own choice.

2. Market Transparency

There is much clarity in this market. The traders in the foreign exchange market have full
access to all market data and information. This will help to monitor different countries’
currency price fluctuations through the real-time portfolio.

3. Dynamic Market

The foreign exchange market is a dynamic market structure. In these markets, the currency
values change every second and hour.

4. Operates 24 Hours

The Foreign exchange markets function 24 hours a day. This provides the traders the
possibility to trade at any time.

Test your Understanding:

1) Distinguish between formal and informal financial markets

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 2) Describe Indian financial system
3) Briefly explain the components of formal financial system
4) Explain the functions of financial system in detail
5) Describe the function of foreign exchange market
6) Write a note of Forex market
1.8 : Suggested Readings / Reference Books:
. E. Gordon and K. Natarajan – Financial markets and services –Himalaya publications
2. Vasant Desai – Indian financial system –Himalaya publications.
3. LM Bhole – Financial institutions and market –Tata McGraw Hill.
4. YM. Khan – Financial services –Tata McGraw Hill
5. Financial Markets Institutions and Services by Taxmann

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