Financial Institutions and Market
Structure, Growth and Innovation
Chapter 1
Nature and Role of
Financial System
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Learning Objective
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Introduction
Broad Issues
What are the necessary pre-conditions to define Financial
System?
Do the forces of demand & supply exist in a financial system?
Is it possible to influence the level of national
income,employment,social wellbeing through variations in the
supply of finance?
In what way financial development itself is affected by
economic development?
Do the free & competitive financial markets allocate
resources more efficiently?
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Financial System
Enhances the rate of capital formation, efficiency of the
function of medium of exchange and facilitate
allocation of resources across space and time in an
uncertain environment
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Functions of Financial System
Facilitates separating ,distributing, trading, hedging,
diversifying, pooling and reducing risks
Allocates resources across space and time
Monitors managers and exerts corporate control
Mobilises saving
Facilitates efficient operation of payment mechanism
Enables economic units to exercise their time preference
Transmutes or transforms financial claims so as to suit
the preference of both savers and investors
Enhances liquidity & better portfolio management
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Structure of Financial System
Financial System : Money, Credit , Finance
The Structure of Financial system consists of :
• specialised & non-specialised financial institutions
• organised and unorganised financial markets
• financial instruments and services which facilitates
transfer of funds
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Structure of Indian Financial System
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Financial Markets
The centers or arrangements that provide facilities for demand
and supply side of financial claims and services.
Classification of Financial Markets
• Money & Capital Markets
• Organised & Unorganised Markets
• Primary & Secondary Markets
• Formal & Informal Markets
• Official & Parallel Markets
• Domestic & Foreign Markets
• Broad & Deep Financial Markets
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Financial Instruments & Services
Financial Assets
Financial securities (Primary & Secondary)
Investment characteristics of Financial assets
• Liquidity • Maturity period
• Marketability • Tax status
• Reversibility • Buy-back options
• Transferability • Volatility of prices
• Transaction costs • Rate of return
• Risk of default
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Equilibrium in Financial Markets
Equilibrium is established when the expected demand
for funds (credit) for short-term & long-term
investment matches with the planned supply of funds
generated out of savings and credit creation.
(Figure A,B &C )
Interest rate can also be fixed irrespective of the equilibrium
rate of interest i.e. Administered Interest rate (Figure D) in
order to match/adjust supply and demand for funds as per
economic policy requirement
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contd...
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Indicators of Financial Development
Finance ratio
Financial Inter-relation ratio
New issue ratio
Intermediation ratio
The ratio of money to national income
Proportion of current account deficit financed from market
Integration of financial sector development
Lower transaction cost
Developed banking sector with private ownership
Well developed supervisory system
Efficient & large non-banking sector
High level of current & capital account convertibility
Well developed secondary markets in all financial assets
More prominence of indirect rather direct technique of monetary policy
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Financial Sector & Economic Development
Theories on the impact of financial development on savings and
investment :
The classical prior voluntary
savings theory
Forced saving or Inflationary
Financing theory
Financial Repression theory
Financial Liberalisation theory
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contd...
The role of financial system in the growth process : to
reduce the cost of accumulating capital.
Policy makers should align private incentives with public
interest in such a way that the scrutiny of financial institutions
by supervisors is supported by supervision of market
participants : Market-aware regulation
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contd...
Possible pattern of relationship : Financial
development & Economic development is symbiotic
“Demand following” financial development
Economic Growth cycle
“Supply leading” financial development
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Cautionary view : Financial system in
development
Little investment in financial market is based genuine long-term
expectations. ( Keynes)
Practical implication of Efficient market.(Tobin's)
Financial markets hardly conform to a model of perfect competition
The casino effect of the financial market
Crowed behavior of the market: growing deviation from equilibrium
prices (boom & bust)
Investor behavior: trade on noise rather than fundamentals
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contd...
The relation between capital and growth : Correlation
Vs. causation
Demand side of investment rather supply of funds may
be the decisive element in take off ( Rostow)
Real growth can not be bought with money alone
(Chandler)
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Fundamental Questions
Whether institutions find the most productive
investment?
Do institutions revalue their assets & liabilities in
response to changed circumstances?
Whether Institutions facilitate the management of risk?
Whether financial institutions transparent in
communication?
How effective is the regulatory and supervisory system?
Do investors and financial institutions learn from past
mistakes?
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Concepts : Financial Development
Efficiency a. Information Arbitrage
b. Fundamental Valuation Efficiency
c. Full Insurance Efficiency
d. Operational Efficiency
e. Allocation Efficiency
Financial Innovations
Financial Engineering
Financial Revolution
Diversification
Financial Repression
Financial Integration
Securitisation
Braod,Wide,Deep and shallow market
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