Mission RBI 2018 - Financial System

Introduction to Financial System: The economic development of any country

depends upon the existence of a well organized financial system. It is the financial
system which supplies the necessary financial inputs for the production of goods and
services which in turn promotes the well being and standard of living of the people of a
country. Thus, the ‘financial system’ is a broader term which brings under its fold the
financial markets and the financial institutions which support the system. The major
assets traded in the financial system are money and monetary assets. The
responsibility of the financial system is to mobilize the savings in the form of money and
monetary assets and invest them to productive ventures. An efficient functioning of the
financial system facilitates the free flow of funds to more productive activities and thus
promotes investment. Thus, the financial system provides the intermediation between
savers and investors which in turn promotes faster economic development.

Constituents of the financial system: The three main constituents of the financial
system are:
1. Financial Assets
2. Financial Intermediaries
3. Financial markets

1. Financial Assets: Financial assets are intangible assets such as bank deposits,
bonds, and stocks, whose values are derived from a contractual claim of what they
represent. Unlike property or commodities, they are not physical (apart from the
documents’ paper).Financial assets are more liquid than tangible assets, i.e. they
can be turned into cash more rapidly.

While land or some other tangible asset has physical value, a financial document
does not until it is converted into cash.

Every financial asset has a corresponding financial liability; it’s that financial liability that
gives financial asset its value.

“First we must know about Asset: An asset is a resource or property having a

monetary/economic value possessed by an individual or entity, which is capable
of producing some future economic benefit. Assets are generally brought in
business to benefit from them and to increase the value of a business.

CLASSIFICATION OF ASSETS: Assets are generally classified in the following

three ways depending upon nature and type:

1. Convertibility: One way of classification of assets is based on their easy

convertibility into cash. According to this classification, total assets are classified
either into Current Assets or Fixed Assets.
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CURRENT ASSETS: Assets which are easily convertible into cash like stock,
inventory, marketable securities, short-term investments, fixed deposits, accrued
incomes, bank balances, debtors, prepaid expenses etc. are classified as current
assets. Current assets are generally of a shorter life span as compared to fixed
assets which last for a longer period. Current assets can also be termed as liquid
assets.

FIXED ASSETS: Fixed assets are of a fixed nature in the context that they are not
readily convertible into cash. They require elaborate procedure and time for their
sale and converted into cash. Land, building, plant, machinery, equipment and
furniture are some examples of fixed assets. Other names used for fixed assets
are non-current assets, long-term assets or hard assets. Generally, the value of
fixed assets generally reduces over a period of time (known as depreciation).

2. Physical Existence: Another classification of assets is based on their physical

existence. According to this classification, an asset is either a tangible asset or
intangible asset.

TANGIBLE ASSETS: Tangible assets are those assets which we can touch, see
and feel. All fixed assets are tangible. Tangible assets are depreciated. Moreover,
some current assets like inventory and cash fall under the category of tangible
assets too. Few examples of such assets include furniture, stock, computers,
buildings, machines, etc.

INTANGIBLE ASSETS: Intangible assets cannot be seen, felt or touched

physically by us. Intangible assets are amortized. Some examples of intangible
assets are goodwill, franchise agreements, patents, copyrights, brands,
trademarks etc. A few examples of such assets include goodwill, a patent,
copyright, a trademark, a company’s brand name, etc.
For information: Amortization is an accounting term that refers to the process of
allocating the cost of an intangible asset over a period of time. It also refers to
the repayment of loan principal over time.

3. Usage: According to a third way of classification, assets are either operating or

non-operating. This classification is based on usage of the asset for business
operation. Assets which are predominantly used for day-to-day business are
classified as operating assets and other assets which are not used in operation
are classified as non-operating.
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OPERATING ASSETS: All assets required for the current day-to-day transaction
of business are known as operating assets. In simple words, the assets that a
company uses for producing a product or service are operating assets. These
include cash, bank balance, inventory, plant, equipment etc.

NON-OPERATING ASSETS: All assets which are of no use for daily business
operations but are essential for the establishment of business and for its future
needs are termed as non-operational. This could include some real estate
purchased to earn from its appreciation or excess cash in business, which is not
used in an operation.

UNDERSTANDING TOTAL ASSETS AND NET ASSETS: The meaning of total

assets is truly reflected in the accounting equation as the sum total of liabilities
and owner’s equity. While “Net Assets” is a term used to state the difference
between total assets and total liabilities. Consequently, it can be noted that net
assets and owner’s equity are virtually the same i.e. both represent the difference
between “Total Assets” and “Total Liabilities”
Total Assets = Total Liabilities + Owner’s Equity
Net Assets = Total Assets – Total Liabilities”

Financial assets can be classified differently under different circumstances, viz. :

A. (i) Marketable assets and (ii) Non-marketable assets
B. (i) Money/cash asset (ii) Debt asset and (iii) Stock assets

A. (i) Marketable Assets : Marketable assets are those which can be easily transferred
from one person to another without much hindrance. E.g.Equity shares of listed
companies, Bonds of PSUs, Government Securities.
(ii) Non-marketable Assets : Non-marketable assets are those assets which cannot be
transferred easily. E.g. FDRs, PF, Pension Funds, NSC, Insurance policy etc.

B. (i) Cash Assets : Cash assets are those assets that may readily be converted to
cash. These assets often retain high levels of liquidity and may be used to ensure the
financial ability of a company or individual to conduct daily operations. E.g. cash, money
market funds, commercial papers.
(ii) Debt Asset : Debt asset is issued by a variety of organizations for the purpose of
raising their debt capital. There are different ways of raising debt capital. E.g.- issue of
debentures, raising of term loans, working capital advances etc.

(iii) Stock Asset : Stock asset is issued by business organizations for the purpose of
raising their fixed capital. There are two types of stock namely equity shares and
preference shares.
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2. Financial Intermediaries: The term financial intermediaries include all kinds of

organizations which intermediate and facilitate financial transactions of both individuals
and corporate customers. Thus, it refers to all kinds of FIs and investing institutions
which facilitate financial transactions in financial markets. They may be in the organized
sector or in the unorganized sector and may be further classified into two types:

(i) 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 investment institutions like Life Insurance Corporation of
India (LIC), mutual funds, investment banks, pension funds etc.

(ii) Money Market Intermediaries: Money market intermediaries supply only short term
funds to individuals and corporate customers. They consist of commercial banks,
cooperative bank, NBFCs etc.

3. Financial markets: A financial market is a market where financial assets and

financial liabilities are bought and sold. Financial Markets perform the essential
economic function of channeling funds from savers who have an excess of funds to
spenders who have a shortage of funds. Financial markets can perform this basic
function either through direct finance in which borrowers borrow funds directly from
lenders by selling them securities or through indirect finance, which involves a financial
intermediary who stands between the lender-savers and borrower-spenders and helps
transfer funds from one to the other. This channelizing of funds improves the economic
welfare of everyone in the society because it allows funds to move from people who
have no productive investment opportunities to those who have such opportunities,
thereby contributing to increased efficiency in the economy.

The financial markets in India can be classified as follows:

(a) Unorganized Markets: In unorganized markets, there are a number of money
lenders, indigenous bankers, traders, etc. who lend money to the public. Indigenous
bankers also collect deposits from the public. There are also private finance companies,
chit funds etc whose activities are not controlled by the RBI. The RBI has already taken
some steps to bring unorganized sector under the organized fold.

(b) Organized Markets: In the organized markets, there are standardized rules and
regulations governing their financial dealings. There is also a high degree of
institutionalization and instrumentalization. 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 types. They are:
(i) Capital Market and
(ii) Money Market.
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(i) 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 more than one year.

Capital market may be further divided into three types namely:

1. Industrial Securities Market
2. Government Securities Market and
3. Long-term Loans Market.

1. Industrial Securities Market: As the very name implies, it is a market for industrial
securities, namely : (i) equity 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 types. They are
(a) Primary market or New Issue Market,
(b) Secondary market or Stock Exchange.

2. 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 money market. The secondary
market for these securities is very narrow since most of the institutional investors tend to
retain these securities until maturity.

Gilt-edged securities are a high-grade investment with very low risk. Typically, these
are issued by blue chip companies that dependably meet dividend or interest payments
because they are well-established and financially stable.

Following features of government securities earned them the name of gilt edged
securities.
1. They have zero income default.
2. There is high rate of return.
3. There is cent per cent liquidity.

3. Long-term Loans Market: Development banks and commercial banks play a

significant role in this market by supplying long term loans to corporate customers. Long
term loans market may further be classified into – (i) Term loans, (ii) Mortgages and (iii)
Financial Guarantees markets.
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(ii) Money Market: Money market is a very important segment of a financial system. It
is the market for dealing in monetary assets of short-term nature. Short-term funds up to
one year and financial assets that are close substitutes for money are dealt in the
money market. Money market provides access to providers and users of short-term
funds to fulfill their investments and borrowings requirements respectively at an efficient
market clearing price.

It performs the crucial role of providing an equilibrating mechanism to even out short-
term liquidity, surpluses and deficits and in the process, facilitates the conduct of
monetary policy. The money market is one of the primary mechanism through which the
Central Bank influences liquidity and the general level of interest rates in an economy.

The Bank’s interventions to influence liquidity serve as signaling device for other
segments of the financial system. The money market functions as a wholesale debt
market for low-risk, highly liquid, short term instruments. Funds are available in this
market for periods ranging from a single day upto a year. Mostly government, banks
and financial institutions dominate this market. It is a formal financial market that deals
with short-term fund management.