Financial Markets & Institutions

1. Definition of financial system

The term ‘financial system’ refers to a system that is concerned with the mobilization of the savings of the public and
providing of necessary funds to the needy persons and institutions for enabling the production of goods and/or for
provision of services. Thus, a financial system can be understood as a system that allows the exchange of funds between
lenders, investors, and borrowers. It consists of complex, closely related services, markets, and institutions used to
provide an efficient and regular linkage between investors and depositors. Financial systems operate at national, global,
and firm-specific levels. It includes the public, private and government spaces and financial instruments which can relate
to countless assets and liabilities.

Features/Characteristics of Financial System

1. Financial system acts as a bridge between savers and borrowers
2. It consists of a set of inter-related activities and services
3. It consists of both formal and informal financial sectors. The existence of both formal and informal ystem is also called
as financial dualism.
4. It formulates capital, investment and profit generation
5. It is universally applicable at firm level, regional level, national level and international level
6. It consists of financial institutions, financial markets, financial services, financial instruments, financial practices and
financial transactions.

4. Defects of Indian Money Market:

The Indian money market is inadequately developed, loosely organised and suffers from many weaknesses.
Major defects are discussed below:
I. Dichotomy between Organised and Unorganised Sectors:
The most important defect of the Indian money market is its division into two sectors- (a) the organised sector and (b)
the unorganised sector. There is little contact, coordination and cooperation between the two sectors.
II. Predominance of Unorganised Sector:
Another important defect of the Indian money market is its predominance of unorganised sector. The indigenous
bankers occupy a significant position in the money- lending business in the rural areas.
III. Wasteful Competition:
The relation between various segments of the money market is not cordial and they generally follow separatist
tendencies.
IV. Absence of All-India Money Market:
Indian money market is divided into small segments mostly catering to the local financial needs
V. Inadequate Banking Facilities:
Indian money market is inadequate to meet the financial need of the economy and vast rural areas still exist without
banking facilities.
VI. Shortage of Capital:
The availability of capital in the money market is insufficient to meet the needs of industry and trade in the country.
VII. Seasonal Shortage of Funds:
A Major drawback of the Indian money market is the seasonal stringency of credit and higher interest rates during a part
of the year.
VIII. Diversity of Interest Rates:
Disparities in the interest rates adversely affect the smooth and effective functioning of the money market.
IX. Absence of Bill Market:
The existence of a well-organised bill market is essential for the proper and efficient working of money market.
Unfortunately, the bill market in India has not yet been fully developed.
Broadly speaking, the functions are of two categories – primary and secondary.

7. Functions of Commercial Banks

The primary functions of a commercial bank are as follows:
1. Accepting Deposits
Commercial banks accept deposits from people, businesses, and other entities in the form of:
Savings deposits – The commercial bank accepts small deposits, from households or persons, in order to encourage
savings in the economy.
Time deposit – The bank accepts deposits for a fixed time and carries a higher rate of interest as compared to savings
deposits.
Current deposits – These accounts do not offer any interest. Further, most current accounts offer overdrafts up to a pre-
specified limit. The bank, therefore, undertakes the obligation of paying all cheques against deposits subject to the
availability of sufficient funds in the account.
2. Lending of Funds
Another important activity is lending funds to customers in the form of loans and advances, cash credit, overdraft and
discounting of bills, etc.
Secondary Functions of Commercial Banks
The secondary functions of a commercial bank are as follows:
A bank acts as an agent to its customers for various services like:
 Collecting bills, draft, cheques, etc.
 Paying the insurance premium, rent, loan installments, etc.
 Working as a representative of a customer for purchasing or redeeming securities, etc. in the stock exchange.
 Acting as an executor, administrator, or trustee of the estate of a customer
 Also, preparing income tax returns, claiming tax refunds, etc.
General Utility Services
There are several general utility services that commercial banks offer like:
 Issuing traveler cheques
 Offering locker facilities for keeping valuables in safe custody
 Also, issuing debit cards and credit cards, etc.

8. Factors affecting Foreign Exchange Rates

1. Inflation Rates
Changes in market inflation cause changes in currency exchange rates. A country with a lower inflation rate than
another does will see an appreciation in the value of its currency.
2. Interest Rates
Increases in interest rates causes a rise in exchange rates
3. Country’s Current Account / Balance of Payments
Balance of payments creates fluctuation in the exchange rate of its domestic currency.
4. Government Debt
A country with government debt is less likely to acquire foreign capital, leading to inflation.
5. Terms of Trade
A country's terms of trade improves if its exports prices rise at a greater rate than its imports prices. A higher demand
for the country's currency and an increase in its currency's value results in an appreciation of exchange rate.
6. Political Stability & Performance
A country with less risk for political turmoil is more attractive to foreign investors, as a result, drawing investment away
from other countries with more political and economic stability.
7. Recession
When a country experiences a recession, its interest rates are likely to fall, decreasing its chances to acquire foreign
capital. As a result, its currency weakens in comparison to that of other countries, therefore lowering the exchange rate.
8. Speculation
If a country's currency value is expected to rise, investors will demand more of that currency in order to make a profit in
the near future. With increase in currency value there will be a rise in the exchange rate as well.

1. Financial System & Functions:

A financial system is a network of financial institutions, financial markets, financial instruments and financial services to
facilitate the transfer of funds. The system consists of savers, intermediaries, instruments and the ultimate user of funds.
The level of economic growth largely depends upon and is facilitated by the state of financial system prevailing in the
economy. Efficient financial system and sustainable economic growth are corollary. The financial system mobilizes the
savings and channelizes them into the productive activity and thus influences the pace of economic development.
Economic growth is hampered for want of effective financial system. Broadly speaking, financial system deals with three
inter-related and interdependent variables, i.e., money, credit and finance.

The financial system provides channels to transfer funds from individual and groups who have saved money to
individuals and group who want to borrow money. Saver (refer to the lender) are suppliers of funds to borrowers in
return with promises of repayment of even more funds in the future. Borrowers are demanders of funds for consumer
durables, house, or business plant and equipment, promising to repay borrower funds based on their expectation of
having higher incomes in the future. These promises are financial liabilities for the borrower-that is, both a source of
funds and a claim against the borrower’s future income.

Main Functions of Financial System

The functions of financial system can be enumerated as follows:

 Financial system works as an effective conduit for optimum allocation of financial resources in an economy.
 It helps in establishing a link between the savers and the investors.
 Financial system allows ‘asset-liability transformation’. Banks create claims (liabilities) against themselves when
they accept deposits from customers but also create assets when they provide loans to clients.
 Economic resources (i.e., funds) are transferred from one party to another through financial system.
 The financial system ensures the efficient functioning of the payment mechanism in an economy. All
transactions between the buyers and sellers of goods and services are effected smoothly because of financial
system.
 Financial system helps in risk transformation by diversification, as in case of mutual funds.
 Financial system enhances liquidity of financial claims.
 Financial system helps price discovery of financial assets resulting from the interaction of buyers and sellers. For
example, the prices of securities are determined by demand and supply forces in the capital market.
 Financial system helps reducing the cost of transactions.

Financial markets play a significant role in economic growth through their role of allocation capital, monitoring
managers, mobilizing of savings and promoting technological changes among others. Economists had held the view that
the development of the financial sector is a crucial element for stimulating economic growth. Financial development can
be defined as the ability of a financial sector acquire effectively information, enforce contracts, facilitate transactions
and create incentives for the emergence of particular types of financial contracts, markets and intermediaries, and all
should be at a low cost. Financial development occurs when financial instruments, markets and intermediaries
ameliorate through the basis of information, enforcement and transaction costs, and therefore better provide financial
services. The financial functions or services may influence saving and investment decisions of an economy through
capital accumulation and technological innovation and hence economic growth. Capital accumulation can either be
modeled through capital externalities or capital goods produced using constant returns to scale but without the use of
any reproducible factors to generate steady-state per capita growth. Through capital accumulation, the functions
performed by the financial system affect the steady growth rate thereby influencing the rate of capital formation. The
financial system affects capital accumulation either by altering the savings rate or by reallocating savings among
different capital producing levels. Through technological innovation, the focus is on the invention of new production
processes and goods.

2. Financial Markets & Components

The group of individuals and corporate institutions dealing in financial transactions are termed as financial markets. The
centers or arrangements that facilitate buying and selling of financial assets, claims and services are the constituents of
financial market. Basically they are classified into two categories:
1. Unorganized Market
2. Organized Market
Unorganized Market
The sector that is not governed by any statutory or legal authority is known as unorganized sector. This sector consists of
the individuals and institutions for whom there are no standardized rules and regulations governing their financial
dealings. They are not under the supervision and control of RBI or any other regulatory body. Local money lenders, Pawn
brokers, Traders, Landlords, Indigenous bankers, etc., who lend money are in the unorganized sector.
Organized Market
The sector that is governed by some statutory or legal authority is known as organized sector. This sector consists of the
institutions for whom there are standardized rules and regulations governing their financial dealings. They are under the
supervision and control of RBI and other statutory bodies. They are further classified into two:
 Capital Market
 Money Market
 Foreign Exchange Market
A. Capital Market
Capital Market refers to the market for long term finance. Financial assets which have a long or indefinite

B. Money Market
Money Market refers to the market for short term finance. Financial assets which have a short period of maturity are
dealt in this market. Near money like Trade Bills, Promissory Notes, Short term government Papers, etc., are traded in
this market.
Composition of money market
The money market comprises of the following:
 Call money market
 Commercial bills market
 Treasury bills market
 Short-term loan market

C. Foreign Exchange Market

Financial markets comprise five key components: the debt market, the equity market, the foreign-exchange market, the
mortgage market, and the derivative market. From the 1980s, each component market has been expanding in size, and
an extensive array of new financial instruments has been initiated, especially in the mortgage market and the derivative
market.
 Debt instruments are traded in the debt market, also often referred to as the bond market. The debt market is
important to economic activities because it provides an important channel for corporations and governments to
finance their operations. Interactions between investors and borrowers in the bond market determine interest
rates.
 Equity instruments are traded in the equity market, also known as the stock market.. It is important because
fluctuations in stock prices effect investors’ wealth and hence their saving and consumption behavior, as well as
the amount of funds that can be raised by selling newly issued stocks to finance investment spending.
 Foreign-exchange markets are where currencies are converted so that funds can be moved from one country to
another. Activities in the foreign-exchange market determine the foreign-exchange rate, the price of one
currency in terms of another.
 A mortgage is a long-term loan secured by a pledge of real estate. Mortgage-backed securities (also called
securitized mortgages) are securities issued to sell mortgages directly to investors. The securities are secured by
a large number of mortgages packaged into a mortgage pool. The most common type of mortgage-backed
security is a mortgage pass-through, a security that promises to distribute to investors the cash flows from
mortgage payments made by borrowers in the underlying mortgage pool.
 Financial derivatives are contracts that derive their values from the underlying financial assets. Derivative
instruments include options contracts, futures contracts, forward contracts, swap agreements, and cap and floor
agreements. These instruments allow market players to achieve financial goals and manage financial risks more
efficiently.