Chapter 1

Financial System:
An Introduction

Chapter Objectives
To understand the

Meaning of financial system

Components of the financial system
Functions of the financial system
Key elements of the financial system
Key elements of a well functioning financial
system
Bank-based and market-based financial
systems
Nature and role of financial institutions and
markets
Link between money market and capital
market
Link between primary market and secondary

The Indian Financial System

Meaning of the Financial

System
A set of sub systems of Financial

Institutions,
Services

Markets, Instruments And

Intermediates with the flow of funds

between savers and borrowers
Facilitates transfer and allocation of
scarce
resources
efficiently
and
effectively

Definition of Financial
System
Financial System is
a complex, well-integrated set of subsystems of
Financial
Institutions,
Markets,
Instruments & Services,
which
facilitates
the
transfer
&
allocation of funds,
efficiently
&
effectively

Components of the Financial

System
1. Financial Institutions
2. Financial Markets
3. Financial Instruments
4. Financial Services

1. Financial
Institutions
Financial

Institutions
are
intermediaries that mobilize savings
and facilitate the allocation of funds
in an efficient manner

1. Types of Financial
Institutions
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

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

2. Financial Markets
Financial

Markets are a mechanism

enabling participants to deal in financial
claims.

The markets also provide a facility in which

their demands and requirements interact

to set a price for such claims.

2. Financial Markets

Types

(cont.)

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

2. Link Between Primary and

Secondary Capital Market
A secondary market is indispensable for the
presence of a vibrant primary market.
The 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 prices in the
secondary market.

2. Functions of Financial
Markets
Enabling economic
units to exercise their time
preference
Separation,

distribution,

diversification

reduction of risk
Efficient payment mechanism
Providing information
Enhancing liquidity
Providing Portfolio Management Services

and

3. Financial
Instruments
Financial Instrument is a claim against a person or

an institution for payment, at a future date, of a

sum of money and/or a periodic payment in the
form of interest or dividend.
The term and/or implies that either of the payments

will be sufficient but both of them may be promised.

E.g. Shares, Debentures, Government Securities

etc.

3. Financial Instruments
(cont.)

Types
Primary Securities

(Equity Shares/ Debentures)

Secondary Securities
Insurance policies)

Distinct Features
Marketable
Tradable

(Bank Deposits/ MF units/

4. Financial Services
Financial Services are those that help with

borrowing & funding, lending & investing,

buying & selling securities, making and
enabling payments & settlements, and
managing
risk exposures in financial
markets

4. Financial Services
(cont.)

Major Categories
Funds Intermediation
Payments Mechanism
Provision of Liquidity
Risk Management
Financial Engineering

Interaction among
Financial System
Components
Interdependent
Interactive
Close Links
Competing with each other

Functions of Financial
Mobilize and allocate
System
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 Wellfunctioning 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
A.Bank-based:

Bank-dominated System,
where a few large banks play a dominant role
& the stock market is not important

B.Market-based: Market-dominated Financial

System, where financial markets play an

important role while the banking industry is
much less concentrated

Financial System Designs

(cont.)

A.In Bank-based Financial System, Banks play

a pivotal role in mobilizing savings, allocating

capital, overseeing the investment decisions of
corporate
managers
&
providing
riskmanagement facilities
B.In

Market-based Financial System, the

securities markets share centre stage with banks
in mobilizing the societys savings for firms,
exerting corporate control, and easing risk
management

(A) 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

(B) 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

Relationship Between the

Financial System and Economic
Growth
Financial System
Facilitates economic activity and growth
Helps accelerate the volume and rate of savings
Lowers financial intermediation costs
Makes innovation least costly
Helps in evaluating assets
Helps the central bank to conduct monetary
policy
Monitors the management of companies

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