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Class : MBA Updated by : Dr. M.C. Garg Course Code : FM- Subject : Management of Financial Services
LESSON-
FINANCIAL SYSTEMS AND MARKETS
STRUCTURE
1.0 Objective 1.1 Introduction 1.2 Concept of Financial System 1.3 Financial Concepts 1.4 Development of Financial System in India 1.5 Weaknesses of Indian Financial System 1.6 Summary 1.7 Keywords 1.8 Self Assessment Questions 1.9 Suggested Readings
1.0 OBJECTIVE
After reading this lesson, you should be able to: (a) Understand the various concepts of financial system (b) Highlight the developments and weakness of financial system in India
1.1 INTRODUCTION
A system that aims at establishing and providing a regular, smooth, efficient and cost effective linkage between depositors and investors is known as financial system. The functions of financial system are to channelise the funds from the surplus units to the deficit units. An efficient financial system not only encourages savings and investments,
it also efficiently allocates resources in different investment avenues and thus accelerates the rate of economic development. The financial system of a country plays a crucial role of allocating scare resources to productive uses. Its efficient functioning is of critical importance to the economy.
1.2 CONCEPT OF FINANCIAL SYSTEM
Financial system is one of the industries in an economy. It is a particularly important industry that frequently has a far reaching impact on society and the economy. But if its occult trappings are stripped it is like any industry, a group of firms that combine factors of production (land, labour and capital) under the general direction of a management team and produce a product or cluster of products for sale in financial market. The product of the financial industry is not tangible rather it is an intangible service. Financial industry as a whole, produces a wide range of services but all these services are related directly or indirectly to assets and liabilities, that is, claims on people, organization, institutions, companies and government. These are the forms in which people accumulate much of their wealth. In simple terms we are referring to paper assets : shares, debentures, deposits, mortgages and other securities. Thus, financial system performs certain essential functions for the economy, including maintenance of payment system (through which purchasing power is transferred from one participant to another i.e. from buyer to seller), collection and allocation of the savings of society, and creation of a variety of stores of wealth to suit the preferences of savers. This brief sketch of functions of financial system gives us its gist. Performance of these functions pre- supposes the existence of financial assets, financial institutions (intermediaries) and financial markets. A combination of these three constitute financial system.
To interpret the financial system and evaluate its performance, it requires an understanding of its functions in an economy. Financial system in fact has the following functions :
Flow of finance in the system takes place between two segments i.e. Surplus Unit and Deficit Unit as shown in Chart I. Surplus unit, having excess of income over current consumption can be public surplus unit or private surplus unit. The former have savings through normal budgetary channels and the retained earnings of public sector enterprises. The latter refer to household savings and non-corporate sector savings but corporate sector savings are dominating in volume. Corporate sector savings depend mainly on profitability and distribution policy of the enterprise. On the other hand size of household savings is a function of capacity, ability and willingness of the people to save which in return depends on numerous factors like psychological, social, economic. On the other end of flow of fund, we have deficit unit which seeks funds for investment or consumption purposes. Their investment and sometimes consumption pattern is outcome of their strategy about future earnings. This in turn is a function of existing stock of capital, state of industry and economy, government policies, potentials of opportunity for new investments. Government and business sector are the major borrowers whose investment normally surpass their savings.
The role of financial system is thus, to promote savings and their channalisation in the economy through financial assets that are more productive than the physical assets. The fund flows in an efficient financial system from less productive to more productive purpose, from unproductive/less productive activities to productive activities and from idle balance to active balances. Thus, ultimate objective is to add value through flow of fund in the system. This means that the operations of financial system are vital to the pace and structure of the growth of the economy. However we must not forget that some of the transfers are to households to acquire consumer goods and services and to government for assorted purposes, including collective consumption. This system plays a significant role in accelerating the rate of economic development which leads to improving general standard of living and higher social welfare.
There is another way to look at financial system. Financial system makes it easier to trade. People trade because they differ in what they have and in what they want. Trade
may be trade in lending (giving up purchasing power now in exchange for purchasing power in the future), trade in risk (reducing economic burden of risks through insurance and forward transactions) and trade in goods. Trade benefits everyone. Thus, financial system is concerned with every one and every one is interacting with the system, consciously or unconsciously. Financial system makes trade easier through its technology of payments (whether through credit or cash), technology of lending (through financial market or direct lending) and technology of risk (taking up insurance policy or contracting in futures market). Technology basically refers to network of institutions, markets and instruments of financial system.
Financial system is changing very fast. Changes are due to two types of innovations. First category of innovation facilitates serving existing needs in new ways. An example is leasing, which enables the user to use the asset without buying it. Second category of innovation uses existing technology to serve new needs. Securitisation of financial assets is an example here. Funds extended in form of loans are tied up. To make use of such tied up funds these financial assets are securitised and liquid resources are raised to extend more loans.
Another dimension of financial system in an economy is the government. It is the government which lays down the rules of the game for financial system i.e. directs how the markets operate, which are permissible instruments and what are operating constraints of financial intermediaries. Intervention of government has two facets : one is ensuring efficiency in the system and second is providing stability and building confidence. A financial system is said to be efficient when the sum of all gains from lending, payment and trade in risk are as large as they can be. An immature financial system needs higher degree of intervention and vice-versa. Government also intervenes in financial system to provide its stability in absence of which the system breaks down and it can be disastrous. There has to be a limit to governmental intervention. Excessive intervention mars innovations. Innovations in financial system is the result of attempts to get out of the restrictive regulations. It is essential to appreciate role of financial system or sector in an
In this context, one must know the distinction between financial assets and physical assets. Unlike financial assets, physical assets are not useful for further production of goods or for earning income. For example X purchases land and building, or gold or silver. These are physical assets since they cannot be used for further production. Many physical assets are useful for consumption only.
It is interesting to note that the objective of investment decides the nature of the asset. For instance if a building is bought for residence purpose, it becomes a physical asset. If the same is bought for hiring, it becomes a financial asset.
Classification of Financial Assets
Financial assets can be classified differently under different circumstances. One such classification is :
(i) Marketable assets (ii) Non-marketable assets
Marketable Assets : Marketable assets are those which can be easily transferred from one person to another without much hindrance. Examples are shares of listed companies, Government securities, bonds of public sector undertakings etc.
Non-Marketable Assets : On the other hand, if the assets cannot be transferred easily, they come under this category. Examples are bank deposits, provident, funds, pension funds, National Savings Certificates, insurance policies etc.
Yet another classification is as follows: (i) Money or cash asset (ii) Debt asset (iii) Stock asset
Cash Asset : In India, all coins and currency notes are issued by the RBI and the Ministry of Finance, Government of India. Besides, commercial banks can also create money by means of creating credit. When loans are sanctioned, liquid cash is not granted.
Instead an account is opened in the borrower’s name and a deposit is created. It is also a kind of money asset.
Debt Asset : Debt asset is issued by a variety of organizations for the purpose of raising their debt capital. Debt capital entails a fixed repayment schedule with regard to interest and principal. There are different ways of raising debt capital. Example are issue of debentures, raising of term loans, working capital advance, etc.
Stock Asset : Stock is issued by business organizations for the purpose of raising their fixed capital. There are two types of stock namely equity and preference. Equity shareholders are the real owners of the business and they enjoy the fruits of ownership and at the same time they bear the risk as well. Preference shareholders, on the other hand get a fixed rate of dividend (as in the case of debt asset) and at the same time they retain some characteristics of equity.
1.3.2 Financial Intermediaries
The term financial intermediary includes all kinds of organizations which intermediate and facilitate financial transactions of both individual and corporate customers. Thus, it refers to all kinds of financial institutions and investing institutions which facilitate financial transactions in financial markets. They may be in the organized sector or in the unorganized sector. They may also be classified into two :
(i) Capital market intermediaries (ii) Money market intermediaries
Capital Market Intermediaries : These intermediaries mainly provide long term funds to individuals and corporate customers. They consist of term lending institutions like financial corporations and investing institutions like LIC.
Money Market Intermediaries : Money market intermediaries supply only short term funds to individuals and corporate customers. They consist commercial banks, co- operative banks, etc.
instrumentalisation. These markets are subject to strict supervision and control by the RBI or other regulatory bodies.
These organized markets can be further classified into two. They are : (i) Capital market (ii) Money market
Capital Market : The capital market is a market for financial assets which have a long or indefinite maturity. Generally, it deals with long term securities which have a maturity period of above one year. Capital market may be further divided into three namely :
(i) Industrial securities market (ii) Government securities market and (iii) Long term loans market
I. Industrial securities market
As the very name implies, it is a market for industrial securities namely: (i) Equity shares or ordinary shares, (ii) Preference shares, and (iii) Debentures or bonds. It is a market where industrial concerns raise their capital or debt by issuing appropriate instruments. It can be further subdivided into two. They are :
(i) Primary market or New issue market (ii) Secondary market or Stock exchange
Primary Market : Primary market is a market for new issues or new financial claims. Hence it is also called New Issue market. The primary market deals with those securities which are issued to the public for the first time. In the primary market, borrowers exchange new financial securities for long term funds. Thus, primary market facilitates capital formation.
There are three ways by which a company may raise capital in a primary market. They are :
(i) Public issue
(ii) Rights issue (iii) Private placement The most common method of raising capital by new companies is through sale of securities to the public. It is called public issue. When an existing company wants to raise additional capital, securities are first offered to the existing shareholders on a pre-emptive basis. It is called rights issue. Private placement is a way of selling securities privately to a small group of investors.
Secondary Market : Secondary market is a market for secondary sale of securities. In other words, securities which have already passed through the new issue market are traded in this market. Generally, such securities are quoted in the stock exchange and it provides a continuous and regular market for buying and selling of securities. This market consists of all stock exchanges recognized by the Government of India. The stock exchanges in India are regulated under the Securities Contracts (Regulation) Act, 1956. The Bombay Stock Exchange is the principal stock exchange in India which sets the tone of the other stock markets.
II. Government Securities Market
It is otherwise called Gilt-Edged securities market. It is a market where Government securities are traded. In India there are many kinds of Government Securities-short term and long term. Long term securities are traded in this market while short term securities are traded in the money market. Securities issued by the Central Government, State Governments, Semi-Government authorities like City Corporations, Port Trusts. Improvement Trusts, State Electricity Boards, All India and State level financial institutions and public sector enterprises are dealt in this market.
Government securities are issued in denominations of Rs.100. Interest is payable half-yearly and they carry tax exemptions also. The role of brokers in marketing these securities is practically very limited and the major participant in this market in the
long term loans. They also help in identifying investment opportunities, encourage new entrepreneurs and support modernization efforts.
Mortgages Market : The mortgages market refers to those centers which supply mortgage loan mainly to individual customers. A mortgage loan is a loan against the security of immovable property like real estate. The transfer of interest in a specific immovable property to secure a loan is called mortgage. This mortgage may be equitable mortgage or legal one. Again it may be a first charge or second charge. Equitable mortgage is created by a mere deposit of title deeds to properties as security whereas in the case of legal mortgage the title in the property is legally transferred to the lender by the borrower. Legal mortgage is less risky.
Similarly, in the first charge, the mortgager transfers his interest in the specific property to the mortgagee as security. When the property in question is already mortgaged once to another creditor, it becomes a second charge when it is subsequently mortgaged to somebody else. The mortgagee can also further transfer his interest in the mortgaged property to another. In such a case, it is called a sub-mortgage.
The mortgage market may have primary market as well secondary market. The primary market consists of original extension of credit and secondary market has sales and re-sales of existing mortgages at prevailing prices.
In India residential mortgages are the most common ones. The Housing and Urban Development Corporation (HUDCO) and the LIC play a dominant role in financing residential projects. Besides, the Land Development Banks provide cheap mortgage loans for the development of lands, purchase of equipment etc. These development banks raise finance through the sale of debentures which are treated as trustee securities.
Financial Guarantees Market : A Guarantee market is a center where finance is provided against the guarantee of a reputed person in the financial circle. Guarantee is a contract to discharge the liability of a third party in case of his default. Guarantee acts as a security from the creditor’s point of view. In case the borrower fails to repay the loan,
the liability falls on the shoulders of the guarantor. Hence the guarantor must be known to both the borrower and the lender and he must have the means to discharge his liability.
Though there are many types of guarantees, the common forms are : (i) Performance Guarantee, and (ii) Financial Guarantee. Performance guarantees cover the payment of earnest money, retention money, advance payments, non-completion of contracts etc. On the other hand financial guarantees cover only financial contracts.
In India, the market for financial guarantees is well organized. The financial guarantees in India relate to :
(i) Deferred payments for imports and exports (ii) Medium and long term loans raised abroad (iii) Loans advanced by banks and other financial institutions These guarantees are provided mainly by commercial banks, development banks, Governments both central and states and other specialized guarantee institutions like ECGC (Export Credit Guarantee Corporation) and DICGC (Deposit Insurance and Credit Guarantee Corporation). This guarantee financial service is available to both individual and corporate customers. For a smooth functioning of any financial system, this guarantee service is absolutely essential.
Importance of Capital Market
Absence of capital market acts as a deferent factor to capital formation and economic growth. Resources would remain idle if finance are not funneled through capital market. The importance of capital market can be briefly summarized as follows :
(i) The capital market serves as an important source for the productive use of the economy’s savings. It mobilizes the savings of the people for further investment and thus avoids their wastage in unproductive uses. (ii) It provides incentives to saving and facilitates capital formation by offering suitable rates of interest as the price of capital.
demand at the option of either the lender or the borrower. In India, call money markets are associated with the presence of stock exchanges and hence, they are located in major industrial towns like Bombay, Calcutta, Madras, Delhi, Ahmedabad etc. The special feature of this market is that the interest rate varies from day to day and even from hour to hour and centre to centre. It is very sensitive to changes in demand and supply of call loans.
Commercial Bills Market : It is a market for bills of exchange arising out of genuine trade transactions. In the case of credit sale, the seller may draw a bill of exchange on the buyer. The buyer accepts such a bill promising to pay at a later date specified in the bill. The seller need not wait until the due date of the bill. Instead, he can get immediate payment by discounting the bill.
In India the bill market is under-developed. The RBI has taken many steps to develop a sound bill market. The RBI has enlarged the list of participants in the bill market. The Discount and Finance House of India was set up in 1988 to promote secondary market in bills. In spite of all these, the growth of the bill market is slow in India. There are no specialized agencies for discounting bills. The commercial banks play a significant role in this market.
Treasury Bills Market : It is a market for treasury bills which have ‘short-term’ maturity. A treasury bill is a promissory note or a finance bill issued by the Government. It is highly liquid because its repayment is guaranteed by the Government. It is an important instrument for short term borrowing of the Government. There are two types of treasury bills namely (i) ordinary or regular and (ii) adhoc treasury bills popularly known as ‘adhocs’.
Ordinary treasury bills are issued to the public, banks and other financial institutions with a view to raising resources for the Central Government to meet its short term financial needs. Adhoc treasury bills are issued in favour of the RBI only. They are not sold through tender or auction. They can be purchased by the RBI only. Adhocs are not marketable in India but holders of these bills can sell them back to 364 days only.
Financial intermediaries can park their temporary surpluses in these instruments and earn income.
Short-Term Loan Market : It is a market where short-term loans are given to corporate customers for meeting their working capital requirements. Commercial banks play a significant role in this market. Commercial banks provide short term loans in the form of cash credit and overdraft. Overdraft facility is mainly given to business people whereas cash credit is given to industrialists. Overdraft is purely a temporary accommodation and it is given in the current account itself. But cash credit is for a period of one year and it is sanctioned in a separate account.
Foreign Exchange Market
The term foreign exchange refers to the process of converting home currencies into foreign currencies and vice versa. According to Dr. Paul Einzing “Foreign exchange is the system or process of converting one national currency into another, and of transferring money from one country to another”.
The market where foreign exchange transactions take place is called a foreign exchange market. It does not refer to a market place in the physical sense of the term. In fact, it consists of a number of dealers, banks and brokers engaged in the business of buying and selling foreign exchange. It also includes the central bank of each country and the treasury authorities who enter into this market as controlling authorities.
Functions : The most important functions of this market are :
(i) To make necessary arrangements to transfer purchasing power from one country to another. (ii) To provide adequate credit facilities for the promotion of foreign trade. (iii) To cover foreign exchange risks by providing hedging facilities.
In India, the foreign exchange business has a three-tiered structure consisting of:
(i) Trading between banks and their commercial customers.
The interest rate structure for bank deposits and bank credits is also determined by the RBI. Similarly the interest rate on preference shares is fixed by the Government at 14%. Normally, interest is a reward for risk undertaken through investment and at the same time it is a return for abstaining from consumption. The interest rate structure should allocate scarce capital between alternative uses. Unfortunately, in India the administered interest rate policy of the Government fails to perform the role of allocating scarce sources between alternative uses.
Recent Trends : With a view to bringing the interest rates nearer to the free market rates, the Government has taken the following steps:
(i) The interest rates on company deposits are freed. (ii) The interest rates on 364 days Treasury Bills are determined by auctions and they are expected to reflect the free market rates. (iii) The coupon rates on Government loans have been revised upwards so as to be market oriented. (iv) The interest rates on debentures are allowed to be fixed by companies depending upon the market rates. (v) The maximum rates of interest payable on bank deposits (fixed) are freed for deposits of above one year. Thus, all attempts are being taken to adopt a realistic interest rate policy so as to give positive return in real terms adjusted for inflation. The proper functioning of any financial system requires a good interest rate structure.
1.3.5 Financial Instruments
Financial instruments refer to those documents which represent financial claims on assets. As discussed earlier, financial asset refers to a claim to the repayment of a certain sum of money at the end of a specified period together with interest or dividend. Examples are Bill of exchange, Promissory Note, Treasury Bill, Government Bond,
Deposit Receipt, Share, Debenture, etc. Financial instruments can also be called financial securities. Financial securities can be classified into:
(i) Primary or direct securities. (ii) Secondary or indirect securities.
Primary Securities : These are securities directly issued by the ultimate investors to the ultimate savers, e.g. shares and debentures issued directly to the public.
Secondary Securities : These are securities issued by some intermediaries called financial intermediaries to the ultimate savers, e.g. Unit Trust of India and mutual funds issue securities in the form of units to the public and the money pooled is invested in companies.
Again these securities may be classified on the basis of duration as follows : (i) Short-term securities (ii) Medium-term securities (iii) Long-term securities Short-term securities are those which mature within a period of one year. For example, Bill of Exchange, Treasury Bill, etc. Medium-term securities are those which have a maturity period ranging between one and five years like Debentures maturing within a period of 5 years. Long-term securities are those which have a maturity period of more than five years. For example, Government Bonds maturing after 10 years.
Characteristic Features of Financial Instruments
Generally speaking, financial instruments possess the following characteristic features:
(i) Most of the instruments can be easily transferred from one hand to another without many cumbersome formalities. (ii) They have a ready market i.e., they can be bought and sold frequently and thus trading in these securities is made possible.
