LBS FS Lecture 1-2

Course on Financial Systems

Study Plan

Text Books
Pathak V Bharati - The Indian Financial
System, 2014
Khan M Y - Indian Financial System, 2013

Highly Recommended Readings

Sharma, Ruchir, Breakout Nations: In pursuit of the
next economic miracle, Allen Lane, 1st Edition 2012
(Available in the library)
: Reading the book will help you tackle group task No
2 better

A Hundred Small Steps: Report of the Committee on

Financial Sector Reforms: Government of India,
Planning Commission, 2009
:Report available at:
http://
planningcommission.nic.in/reports/genrep/rep_fr/cfsr_all

Some More Recommended Readings

Goldman Sachs Research
BRICS
Global Economics Paper No 99: Dreaming with Brics
(October 2003)
Global Economics Paper No 192: Long term outlook for
Brics and N-11 post crisis (December 2009)
Brics monthly issue No 11/7: A progress report on the
building of the Brics (July 2011)
INDIA
Global Economics Paper No 169: Ten things for India to
achieve its 2050 potential (June 2008)

THE ABOVE HAS BEEN EMAILED TO YOU.

EXPLORE THE SITE FOR A LOT MORE

Group Task 1
Reports (15 marks) and
presentations (10 marks)
on
Financial systems of Select
Countries

Group Presentations
Deadlines
All teams to email their presentations to me
and the class reps by 5.30 pm on the 24th
of January, 2016
Presentations (2 per class) commence in
the 1st class in the last week of January
2016
Topics
Topics for various groups are given in the
next slide
Form
All members to jointly present
30 minutes each (25 min for presentation &
5 min for Q&A/Other interventions)
Role of class reps

Order of presentations as follows

Individual presentations will be separately
evaluated as well

Group
Group
Group
Group
Group
Group
Group
Group

08.
07.
06.
05.
04.
03.
02.
01.

Japan
Korea
Russia
France
Taiwan
Brazil
UK
China

What will you cover in group work 1?

Economy
Government
Central Bank
Stock exchange (s)
Important industries
Other markets: forex, debt, commodities
Regulatory System for financial markets
Recent developments/ Other important
aspects
Evaluation as investment destination for US
based FIIs desirous of investing in the world
equity markets on a long term basis

Group Task 2 (5 marks)

You are going to be handed over (not really) on the 1 st of

January 2016 for managing, a sum of $ 10 billion, which
can be invested only in listed stocks in the selected
countries (not more than 5 companies per country). The
time horizon of the investment will be a minimum of 5
years, say 2016-20.
Decide
(1)the percentage of investible funds to be invested in the
stock market of the country that you are analysing, and
(2) 3 to 5 companies which you find worthy of investment
()Email the report by 10th Feb 2016 to me and one group
member will make a brief (5 min) presentation in the
class, on a suitable day after the first round of group
presentations is over.
()After all the groups have made their presentations, the
whole house will discuss the matter

Financial system
Introduction

Meaning of Financial
System
A set of sub systems of financial institutions,
markets, instruments and services.
Intermediates with the flow of funds between
savers and borrowers.
Facilitates transfer and allocation of scarce
resources efficiently and effectively.

Types of Financial System

Formal financial system:

Organized, institutional and regulated

Informal financial system:

Advantages: Low transaction costs

Minimum default risk
Transparency of
procedures

Disadvantages: Wide range of interest

rates
Higher rates of interest
Unregulated

Components of the Financial

System
Financial
Financial
Financial
Financial

Institutions
Markets
Instruments
Services

Types of Financial Institutions

Banking and Non Banking
Banking: creators and purveyors of

credit.

Types: Commercial Banks

Cooperative Banks

Non-Banking :purveyors of credit

Types: Developmental financial institutions;
Mutual Funds;
Insurance companies;
NBFCs

Functions of Financial
Institutions
Provide three transformation services:
Liability, asset and size transformation
Maturity transformation
Risk transformation

Financial Markets
Types:
Money Market A market for short -term debt
instruments

. Capital Market - A market for long

-term equity and debt instruments

Segments:
Primary Market A market for new issues
Secondary Market A market for trading outstanding
issues

Link Between Primary & Secondary

Capital markets

A buoyant secondary market

indispensable for the presence of a
vibrant primary market
Secondary market provides a basis
for the determination of prices of
new issues
Depth of the secondary market
depends on the primary market
Bunching of new issues affects

Financial Instruments
Types : Primary

Secondary

Distinct Features : Marketable

Tradeable
Tailor-made

Financial Services
Major categories : Funds
Intermediation
Mechanism

Payments
Provision of

liquidity

Risk

Management
Engineering

Financial

Functions of Financial system

Mobilise and allocate savings

Monitor corporate performance
Provide payment and settlement systems
Optimum allocation of risk bearing and reduction
Disseminate price related information
Offer portfolio adjustment facility
Lower the cost of transactions
Promote the process of financial deepening and
broadening

Key elements of a well -functioning financial

system

A strong legal and regulatory environment

Stable money
Sound public finances and public debt
management
A central bank
Sound banking system
Information system
Well -functioning securities market

Financial system designs

Types : Bank based
Market based

Market -based Financial

System
Advantages:
Provide attractive terms to both investors and borrowers
Facilitate diversification
Allow risk sharing
Allow financing of new technologies

Drawbacks:
Prone to instability
Exposure to market risk
Free rider problem

Bank based Financial

System
Advantages:

Close relationships with parties

Provide tailor made contracts
Efficient inter-temporal risk sharing
No free rider problem

Drawbacks:

Retards innovation and growth

Impedes competition

Functions of Financial
Markets

Enabling economic units to exercise their time preference

Separation, distribution, diversification and reduction of risk
Efficient payment mechanism
Providing information
Enhancing liquidity
Providing portfolio management services.

Functions
The main function of a financial system is the
collection of savings and their distribution for
investment, thereby stimulating capital formation
and, to that extent, accelerating the process of
economic growth. The financial system is a link
between the savers (savings-surplus economic
units) and the investors (saving-deficit economic
units). It is made up of all those channels
through which savings become available for
investment.
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Organisation
The organisation of the financial system
comprises of three inter-related components,
namely, financial intermediaries, financial
markets and financial assets/instruments
(securities).

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Financial Intermediaries
Financial intermediaries (FIs) represent a significant
change in the whole process of a transfer of choice of
investment from an individual saver to an institutional
agent. They convert primary securities with a given set of
characteristics, into indirect securities with very different
features. A primary security is a security issued by a nonfinancial economic unit. A security issued by a financial
intermediary is an indirect security. The ability of FIs to
transform a primary security into an indirect security
makes it more attractive to both the borrowers and the
lenders. The pooling of funds by an FI leads to a
number
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of indirect and derived benefits that add greatly to the

effectiveness and efficiency of the savings-investment
process. The benefits/services associated with the
tailoring of financial assets according to the desires of
the savers and investors are: (i) convenience in terms of
denomination and liquidity, (ii) lower risk due to
diversification of the portfolio, (iii) expert management of
the portfolio and (iv) lower cost resulting from economies
of scale. A diversified structure of FIs in a matured and
sophisticated financial system consists of banks, NBFCs,
mutual funds, insurance organisations and so on. With a
variegated structure, these are able to mobilise savings
from the widest section of the investing public and
channelise them to a cross-section of economic/industrial
enterprises.
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Financial Markets
Financial markets are a significant component of
the financial system. They are not a source of
funds, but they act as a facilitating organisation
and link the savers and investors, both individual
as well as institutional. As facilitating
organisations, financial markets provide a wide
variety of specialist institutional facilities. Based
on the nature of funds which are their stock-intrade, they are classified into: (i) money markets
and (ii) capital/securities markets.
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Money Markets
Money
market
is
a
market
for
dealing
in
monetary/financial assets of a short-term nature,
generally less than one year. Its broad objectives are to
provide (i) an equilibrating mechanism for evening out
short-term surpluses and deficiencies in the financial
system, (ii) a focal point of central bank (RBI) intervention
for influencing liquidity in the economy through a variety
of instruments, and (iii) a reasonable access to the
users of short-term funds to meet their requirements at
realistic/reasonable price/cost. The money market
organisation comprises of a number of interrelated submarkets such as call market, T-bills market, commercial
bills market, CP market, CD market, repo market, etc.
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Capital Markets
Capital/securities market is a market for long-term funds.
It has two segments: primary/new issue market and
secondary/stock exchange/market. The primary market
deals in new securities, offered to the investors for the
first time. It performs a triple-service function, at the
different stages of the issue, namely, origination, that is,
investigation, analysis and processing of new issue
proposals; underwriting; and distribution of securities
to the investors. The stock exchange is a market for
existing securities. It discharges three vital functions: it
acts as a nexus between savings and investment, it
provides liquidity to investors by offering a place for
transaction in securities and it helps in continuous price
formation.
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Financial
Assets/Instruments
A financial asset/instrument/security is a claim on
a stream of income and/or assets of another
economic unit and is held as a store of value and
for the expected return. There are three types of
financial assets:

primary/direct,

Indirect, and

derivatives.

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Primary Security
A primary security is a security issued by a nonfinancial economic unit, such as ordinary/
preference
shares,
debentures/bonds
and
innovative
debt
instruments
including
participating, convertibles, warrants and so on.

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Indirect Security
An indirect security is a security issued by an FI
such as units of mutual funds. It is based on an
underlying primary security. The pooling of funds
by an FI and converting a primary security into an
indirect security is associated with a number of
benefits, namely, convenience, diversification,
expert management and lower cost.

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Derivative Instruments
A derivative instrument includes: (i) a security
derived from a debt instrument, share, secured or
unsecured loan, risk instrument, contract for
differences or any other form of security and (ii) a
contract which derives its value from the
prices/index of prices of the underlying
securities. It is an instrument of risk
management. The most commonly used
derivative contracts are forwards, futures and
options.
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A forward contract is an agreement to exchange an

asset for cash, at a predetermined future date
specified today. At the end of the contract, one
can enter into an offsetting transaction by paying
in the difference in the price. It is settled by the
delivery of the asset on the expiration date.

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Future contracts are transferable specified

delivery forward contracts. They are agreements
between two counterparties to fix forward the
term of an exchange/lock-in the price today, of an
exchange that will take place between them at
some fixed future date, ranging between 3 to 21
months. Depending on the underlying asset,
future contracts could be stock futures or index
futures.

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Options give the holder the right (but not the

obligation) to buy (call option) or sell (put option)
securities
at
a
predetermined
price
(strike/exercise price) within/at the end of a
specified period. In order to acquire the right of
option, the buyer pays to the seller, an option
premium as the price for the right. He can lose no
more than the option premium paid but his
possible gain is unlimited. The sellers possible
loss is unlimited but his maximum gain is
restricted to the option premium charged by him.

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