Indian Financial System

Financial System
 A financial system functions as an intermediary and facilitates
the flow of funds from the areas of surplus to the areas of
deficit.

 A Financial System is a composition of various institutions,

markets, regulations and laws, practices, money manager,
analysts, transactions.

 It helps in economic development of a nation by proper

allocation on funds to various economic units like corporate
sector, government and household sector
 Van Horne defined the financial system as the
purpose of financial markets to allocate savings
efficiently in an economy to ultimate users either for
investment in real assets or for consumption.
 Christy has opined that the objective of the financial
system is to "supply funds to various sectors and
activities of the economy in ways that promote the
fullest possible utilization of resources without the
destabilizing consequence of price level changes or
unnecessary interference with individual desires.“
 According to Robinson, the primary function of the
system is "to provide a link between savings and
investment for the creation of new wealth and to
permit portfolio adjustment in the composition of the
existing wealth."
 word "system", in the term "financial system", implies a set of
complex and closely connected or interlined institutions, agents,
practices, markets, transactions, claims, and liabilities in the
economy. The financial system is concerned about money,
credit and finance-the three terms are intimately related yet are
somewhat different from each other
Inter-relationship in financial
system
 Functions of financial system
•to influence variables like
interest rates or inflation through
govt. intervention
PolicyFinancial
•protection against life, health and
income risks by sale of life and
health insurance and property
insurance policies.
•provide various instruments to
reduce risk in investment
•Public saving are channelised which-
•promise future income flows.
•result in production of goods and
services
Savings provide the investor with the
opportunity to liquidate
investments like stocks bonds
debentures whenever they
Liquidity need the fund.
System
•offers convenient mode for
payment of goods and
Risk Payment services. E.g.Cheque system,
credit card system etc
•The cost and time of
transactions are drastically
reduced.
Financial system in India
Is an institutional framework existing in a country to enable
financial transactions.
Three main parts

 Financial markets (money market, capital market, forex market,

etc.)
 Financial institutions (banks, mutual funds, insurance
companies, etc.)
 Financial instruments (loans, deposits, bonds, equities, etc.)
 Financial Services

 * Regulation is another aspect of the financial system (RBI,

SEBI, IRDA, FMC)
 Money market
Financial Markets Capital Market

A Financial Market can be defined

 as the market in which financial instruments
are created or transferred.
 As against a real transaction that involves
exchange of money for real goods or
services, a financial transaction involves
creation or transfer of a financial asset.
 Financial Assets or Financial Instruments
represents a claim to the payment of a sum of
money sometime in the future and /or periodic
payment in the form of interest or dividend.
 Financial Markets can be classified as:
1. Money Market: Deals with transactions related to
short-term instruments with maturity period less than
one year.
 Organised(Banks)

 Unorganised (money lenders, chit funds, etc.)

2. Capital Market: Deals with transactions related

to long-term instruments with maturity period greater
than one year.
 Primary Market
 Secondary Market
Money Market
 Is a wholesale debt market for low-risk,
highly-liquid, short-term instruments.

 Funds are available for periods ranging from

a single day up to a year.

 dominated mostly by government, banks and

financial institutions.
Money Market (continued)

 Main function - To channelize savings into

short term productive investments like
working capital
 Major participants- RBI and Commercial
Banks
 Purpose-
 Maintain equilibrium mechanism for short
term surplus and deficiencies
 RBI role is to influence liquidity
Capital Market
The capital market is designed to finance the
long-term investments. The transactions
taking place in this market will be for periods
over a year.
 Deals in long term instruments and sources of
funds
 Capital Market Primary Market

Secondary Market
Capital Market (continued)

 Purpose for these resources

 Provided resources needed by medium and large
scale industries for-
 Expansion
 Capacity Expansion

 Investments

 Mergers and Acquisitions

 Main Activity
 Functioning as an institutional mechanism to channelize
funds from those who save to those who needed for
productive purpose
 Provides opportunities to various class of individuals and
entities.
Primary Market
 part of the capital markets that deals with the issue of new
securities.
 Helps companies in raising funds through issue of securities like
shares and debentures.
 Features of primary markets are:
 market for new long term equity capital. The market where the
securities are sold for the first time. Therefore it is also called the
new issue market (NIM).
 the securities are issued by the company directly to investors.
 The company receives the money and issues new security
certificates to the investors.
 New issues are used by companies for the purpose of setting up
new business or for expanding or modernizing the existing
business.
 The primary market performs the crucial function of facilitating
capital formation in the economy.
 The financial assets sold can only be redeemed by the original
holder.
Primary Market (continued)

 Methods of issuing securities in the primary

market are:
 Initial public offering;
 Rights issue (for existing companies);
 Preferential issue.
 Offer for sale
 Book Building
 Placement method

 Governed by SEBI (Securities and Exchange Board of

India).
Secondary Market
 The secondary market, also known as the
aftermarket, is the financial market where previously
issued securities and financial instruments such as
stock, bonds, options, and futures are bought and
sold
 Operates through stock exchanges
 Functions
 it helps in providing liquidity to investments
already made,by offering a place of transaction in
securities
 Nexus between saving and investment

 Continuous price formation

Stock Exchanges
 They are auction markets for securities.
 Transaction at stock exchange occur by placing an order.
 Types of Orders:
 Limit Orders -the broker is required to sell or buy a particular
stock at a pre-specified price
 Best Rate Order
 Immediate or cancel order
 Limited Discretionary Order
 Stop Loss Order -states a price level which if reached turns the
order into a market order. As a result the broker is required to sell
the stock.
 Trailing stop order-As compared to the stop loss order, the
trailing stop order protects your profit.
 Open Order
 Primary Markets Secondary Markets
When companies need financial The place where such securities are
resources for its expansion, they borrow traded by these investors is known as
money from investors through issue of the secondary market.
securities.
Securities issued Securities like Preference Shares and
a)Preference Shares Debentures cannot be traded in the
b)Equity Shares secondary market.
c)Debentures
Equity shares is issued by the under Equity shares are tradable through a
writers and merchant bankers on behalf private broker or a brokerage house.
of the company.
People who apply for these securities Securities that are traded are traded by
are: the retail investors.
a)High networth individual
b)Retail investors
c)Employees
d)Financial Institutions
e)Mutual Fund Houses
f)Banks
One time activity by the company. Helps in mobilising the funds for the
investors in the short run.
 Financial Institution
 Financial institutions help in “channeling funds between surplus
and deficit agents”
 A financial institution is an entity that connects surplus and
deficit agents.
 An example of a financial institution is a bank that transforms bank
deposits into bank loans.
 Through the financial institutions,
 certain assets or liabilities are transformed into different assets or
liabilities.
 They channel funds from people who have extra money (savers) to
those who do not have enough money to carry out a desired
activity (borrowers).
Function performed by
financial institutions
 Maturity transformation:-
Converting short-term liabilities to long term assets
(banks deal with large number of lenders and borrowers,
and reconcile their conflicting needs)
 Risk transformation:-
Converting risky investments into relatively risk-free ones.
(lending to multiple borrowers to spread the risk)
 Convenience denomination:-
Matching small deposits with large loans and large
deposits with small loans
Advantages of financial
institutions
 Cost advantage:-
over direct lending/borrowing
 Market failure protection:-
The conflicting needs of lenders and
borrowers are reconciled, preventing market
failure
Financial Institutions
 Regulatory
 RBI
 SEBI
 Participatory
 Banks
 Insurance Companies
 ORGANIZATION OF BANKING SYSTEM
Reserve Bank of India

Scheduled Banks Non-Scheduled Banks

State Co-op Commercial Central Co-operative Commercial

Bank Banks Banks and Primary Banks
Credit Societies
Indian Foreign

Public Sector Private Sector

Banks banks
 Reserve Bank of India

 It is the central bank of India.

 Established to guide, monitor, regulate, promote and
guide the Indian financial system.
Functions of RBI
 Currency issuing authority
 Acts as banker the central and state governments
 Serves as banker’s bank
 Foreign exchange control authority
 Exercises monetary control through:
-Bank Rate
-Reserve requirements: CRR and SLR
-Open market operations
 Undertakes developmental activities
 Commercial Banks
 Most important depositors and disbursers of
finance.
 They are expected to hold a part of the
deposits in the form of ready cash, known as
cash reserves as prescribed by RBI.

Scheduled Banks
 Scheduled banks are those that are included in
the second schedule of Banking Regulation Act,
1949; the others are non-scheduled banks.
 Scheduled Banks
Requirements that should be fulfilled to be a
Scheduled bank:

A bank must have a paid-up capital and reserve of

not less than Rs. 5 lakh,

It must ensure that its affairs are not conducted in

a manner detrimental to the interests of its
depositors.
Liabilities and Assets of a Bank
LIABILITIES ASSETS

1. Demand deposits 1. Cash in hand

a. Current deposits 2. Balances with RBI
b. Savings deposits 3. Assets with the banking
c. Call deposits system
2. Time deposits 4. Investments in
3. Other liabilities Government and other
approved securities
(e.g. borrowings form RBI,
refinance form IDBI, 5. Bank Credit
NABARD etc.) a. Demand and Term loans
b. Cash Credit/Overdraft
arrangement
c. Bill financing
 Insurance

From an individual’s point of view, insurance is an

economic device whereby the individual can
substitute a small definite cost (premium) for a large
uncertain financial loss [the contingency insured
against] that would have to be borne if insurance
was not available.
Classification of Insurance
1.Life Insurance: A life policy covers risk of death due
to natural causes as also due to accidents.
2.General Insurance: Insurance other than the life

insurance fall under the category of general insurance.

a.Fire Insurance

b.Marine Insurance

c.Miscellaneous Insurance

Insurance Regulatory and Development

Authority: Regulates, promotes and ensures orderly
growth of the insurance business and reinsurance
business.
Financial Institutions
 Industrial Development Bank of India
 established on July 1, 1964 under an Act of Parliament Industrial Finance
Corporation of India
 provides financial assistance for the establishment of new projects as well
as for expansion,diversification, modernisation and technology upgradation
of existing industrial enterprises.
 Provide direct loans,soft loans,underwriting to
shares,sanction of foreign currency loans,short term working
capital loans.
 Industrial Credit and Investment Corporation of India
 In 1955, The ICICI was incorporated at the initiative of World Bank for
providing medium-term and long-term project financing to Indian
businesses
 Industrial Investment Bank of India
 initially set up as Industrial Reconstruction Corporation
Limited during 1971 then renamed Indl Reconstruction bank
of India wef Mar 20, 1985 under IRBI Act 1984 to take over
the function of IRC.
 During 1997, was converted to a joint stock company by
naming it Industrial Investment Bank of India.

 functions were to provide finance for industrial rehabilitation

and revival of sick industrial units by way of rationalisation,
expansion, diversification and modernisation
 Export and Import Bank of India
 State Financial Corporations
 Investment Institutions
 Non Banking Financial Companies
 Investment Trusts and Investment Companies
 Mutual Benefit Funds
 Merchant Banks
 Hire Purchase Finance Companies
 Lease Finance Companies
 Housing Finance Companies
 Non-Housing Bank
 Venture Capital Funding Companies
 Financial Instruments
 They represent claim on a stream of income and/or
asset of another economic unit and are held as a
store of value for return that is expected
 A financial instrument is a contract that represents:
a financial asset of one party, And a financial
liability/equity instrument of the other party.
 Financial Instruments Primary/Direct
Indirect
Derivative
Primary/Direct Security
 Security issued by non-financial economic units
 Main types-
 Ordinary/Equity share-
 ownwership security
 gives percentage ownership right in capital of company
 can give decision making right.
 The income received from shares is called a dividend, and a person owning
shares is called a shareholder.
 Debentures-
 creditorship security
 holders get prespecified interest and first claim on assets of entity

 Preference shares-
 Hybrid security(both equity and debentures)
 Both ownership and creditorship privileges
Indirect Securities
 Are securities issued by financial institutions
 The Pooling of funds leads to no. of indirect
and derived benefits that add to its efficiency
and effectiveness
 Features-
 Expert management
 Suitable according to size and scale of lender and
borrower
 Variety of service
 Low risk
Derivative Instrument
 Is product whose value is derived from value of
underlying assets in contractual manner
 Help in Partially or fully transfer price risk by locking
in asset prices
 Forword contract-
 Agreement to exchange asset for cash at predermined
future.
 They are exposed to default risk by counterparty.
 Future contract
 Are transferable specific delivery forward contracts.
 It is agreement b/w two counterparties to fix the terms of
exchange /lock in price today for a exchange that will take
place at some fixed future date.
Participants:
Hedgers: Hedgers wish to eliminate or reduce
the price risk to which they are already
exposed
Speculators: Speculators are those class of
investors who willingly take price risks to
profit from price changes in the underlying.
Arbitrators : Arbitrageurs profit from price
differential existing in two markets by
simultaneously operating in two different
markets.
 Options
 Contracts that give holder the right to buy or sell
securities at a pre-determined price within/at end of
specified period.
 In order to acquire right to option ,option buyer pays
the option seller an option premium which is price
payed for the right.
 Option buyer

Max Loss= option premium

Gain=unlimited
Option writer
Loss=unlimited
Max. gain=option premium
Some Instruments in Money
Market
 Call /Notice money market
 Treasury bills market
 Markets for commercial paper
 Certificate of deposits
 Bills of Exchange
 Money market mutual funds
 Promissory Note
 Call/Notice Money market
 Is a part of the national money market
 Day-to day surplus funds mainly of banks are traded
 Participants that can both borrow and lend
(e.g. Commercial banks, DFHI, STCI etc.)
That can only lend
(e.g. LIC, UTI, Mutual funds etc.)

 Purely unsecured market as no collaterals are offered for

securing lending and borrowing

 Short term in nature

 Maturity of these loans vary from 1 to 15 days

 Call money: Money Lent for 1 day
 Notice money: Money Lent for 1-14 days
 Convenient interest rate
 Highly liquid loan repayable on demand
 Non bank finance institutions are not allowed from
August 6,2005
 Purpose:
 To help commercial banks by discounting commercial bills.
 To help the banks in meeting the CRR requirement
 To meet the sudden demands for funds
 To meet the temporary mismatches.
Certificate of Deposit
 This scheme was introduced in July 1989, to enable the banking
system to mobilise bulk deposits from the market, which they
can have at competitive rates of interest
 Defined as short term deposit by way of usance promissory
notes.
The Major features are:
 Who can issue: Scheduled commercial banks and All India
Financial Institutions within their `Umbrella limit’.
 CRR/SLR: Applicable on the issue price in case of banks
 Investors: Individuals (other than minors), corporations,
companies, trusts, funds, associations etc
 Maturity - Min: 7 days Max : 12 Months (in case of FIs
minimum 1 year and maximum 3 years).
 Amount Min: Rs.1 lac, beyond which in multiple of Rs.1 lac
 Interest Rate: Market related. Fixed or floating
 Loan Against collateral of CD not permitted
 Pre-mature cancellation Not allowed
 Transfer Endorsement & delivery. Any time
 Nature Usance Promissory note. Can be issued in
Dematerialisation form wef June 30, 2002
 Free negotiability and limited flexibility
 Permitted by the RBI to banks
Other conditions
 If payment day is holiday, to be paid on next preceding
business day
 Issued at a discount to face value
 Duplicate can be issued after giving a public notice & obtaining
indemnity
Commercial Papers
 Short-term, unsecured promissory notes issued at a discount to
face value by well known companies with a strong and high
credit- rating.
 It was introduced in India in 1990.
 Can be issued in the
 physical form (Usance Promissory Note)
 demat form
 When issued in physical form are negotiable by endorsement
and delivery and hence, highly flexible
 Corporates, primary dealers (PDs) and the All-India Financial
Institutions (FIs) are eligible to issue CP.
 Sold directly by the issuers to investors or through agents like
merchant banks and security houses.
 Maturity period: 15 days – 1 year.
 Issued in multiples of Rs. 5 lakh ;the amount
invested by a single investor should not be less than
Rs. 5 lakh.
 They usually have a buy-back facility.
 Flexible Maturity
 Low interest rates with compared to banks.
 Imparts a degree of financial stability to the system.
 Commercial Paper (CP) is popular, among highly
rated entities, as a tool for diversifying their
sources of short term borrowings and for
reducing the cost of such borrowings
Promissory Note
 Referred as note payable in accounting

 It is a contract detailing the terms of a promise by one party

(the maker) to pay a sum of money to the other (the payee).

 The obligation may arise from the repayment of a loan or from

another form of debt.

 For example, in the sale of a business, the purchase price might

be a combination of an immediate cash payment and one or
more promissory notes for the balance.
Treasury Bills
 Short-term promissory notes issued by the
government to meet their short-term obligations.
 They are useful in managing short-term liquidity.
 There are no treasury bills issued by State
Governments.
 The RBI acts as an agent for issuing T-Bills.
 Subscribers: Banks, primary dealers, financial
institutions, insurance companies, provident funds,
NBFCs, FIIs and state governments.
 Treasury bills are available for a minimum
amount of Rs.25,000 and in multiples of Rs.
25,000.
 At present, the Government of India issues
three types of treasury bills through auctions,
namely, 91-day, 182-day and 364-day.
 Treasury bills are issued at a discount and are
redeemed at par.
Money Market Mutual Funds
 MMMFs were set up to make available the benefits of
investing in money markets to small investors.
 MMMFs invest primarily in money market instruments
of very high quality and of very short maturities.
 MMMFs can be set up by commercial banks,RBI and
public financial institutions either directly or through
their existing mutual fund subsidiaries.
 MMMFs are regulated and governed by SEBI.
 Schemes offered can either be
 open- ended
 close – ended.
  INSTRUMENTS IN INTERNATIONAL MARKETS

Equity Instruments
Debt Instruments
-Global Depository Receipts
-Euro Bonds
-American Depository Receipts
-Foreign Bonds
-Euro Notes
 Global Depository Receipts &
American Depository Receipts
 A GDR or ADR means any instrument in the form of a
Depository receipt or certificatecreated by the Overseas
Depository Bank (ODB) outside India and issued to non-
resident investors against the issue of ordinary shares or
foreign currency convertible bonds of issuing company.

 These are negotiable instruments denominated in US $

representing a non-US company’s publicly traded, local
currency equity shares.

 The issue of such instruments involves the delivery of

ordinary shares of an Indian company to a domestic
custodian bank in India, which in turn instructs an
overseas depository bank to issue GDR/ADR on a
predetermined ratio.
 The GDR/ADR can be sold outside India in their
existing form.

 The underlying shares (arising after redemption of

GDR/ADR) can also be sold in India.

 While ADRs are listed on the US stock exchanges, the

GDRs are usually listed on a European stock
exchange.

 A GDR/ADR may evidence one or more GDS/ADS.

 Each GDS/ADS represent underlying share of Issuing

company.
 Euro Bonds
 Eurobonds are bonds that are issued for sale outside the
issuer’s home country.
 They can be issued in the currency of the foreign
country, or another currency.
 Interest payments and principal are to be returned to
the holder in the currency in which the bond was issued.
 In most cases, the interest is paid annually.
 The Eurobond marketis extremely liquid. While the
majority of the trading is centralized around London’s
trading hours.
 Eurobond trading takes place 24 hours a day
worldwide.
 Eurobonds are named after the currency they
are denominated in. For example, Euroyen
and Eurodollar bonds are denominated in
Japanese yen and American dollars
respectively.
 A Eurobond is normally a bearer bond,
payable to the bearer.
 Foreign Bonds

 Bonds issued by foreign entities for raising

medium to long-term financing from domestic
money centers in their domestic currencies.
 A bond issued in a particular country by a foreign
borrower (or) a bond sold by a foreign borrower,
denominated in the currency of country in which it
is sold and is underwritten & syndicated by
national underwriting syndicate in the lending
country .
 Foreign bonds are floated in the domestic
capital markets (and are in the domestic
currency of those markets) by nonresident
entities.
 These bonds are different from Euro bonds in
the sense that they are governed by the
regulations of the country in which they are
issued whereas Euro bonds are not.
 The bonds are generally named on the basis
of the capital markets in which they are
floated.
 Types of Foreign Bonds
 Yankee Bonds: Yankee bond is a dollar
denominated bond issued in U.S by a non-U.S.
borrower in the U.S. market.
 Samurai bond: Samurai bonds are yen
denominated bonds issued in Japan by a non-
Japanese borrower.
 Bulldog bonds: Bulldog bonds are pound
denominated bonds issued in U.K. domestic
market by a non U.K. borrower.