Financial Markets and Institutions

Chapter-1
Introduction

1
Books
• 1) Financial Institutions and Markets (structure Growth and
Innovations)
By L M Bhole , Jitendra Mahakud-
• Tata McGraw-Hill
2) Indian Financial System : MY Khan
• Tata McGraw-Hill

2
Financial Markets and Institutions

• What is a market?
• What is Financial market
• Who are the participants?

3
Overview-Basic Units

(Households ) Make Profit

Consume Services
Surplus/
/Save Payments Save
Invest/ (Industry/
Invest
Borrow Business)
Borrow

4
Overview
• Savers and Investors

Money
Saving
Surplus
Saving
(Invest
Deficit
/Lend))
(Borrow)

5
Overview
Overview of Financial System

Financial
Savers Institutions Investors

Financial Instruments
Financial Markets
6
The Structure of Indian Financial System

• Adequate capital is necessary for economic

development.
• Financial systems are crucial to capital formation.
• The main function of Financial System is the collection of
savings and their distribution for industrial investment.
• This stimulates capital formation and to that extent
accelerates economic growth.
• The process of capital formation in an economy involves
following activities:
• 1) Savings 2) Finance 3) Investment.
7
Process f Capital Formation in an Economy

Capital Formation

Finance
Savings Investment

8
Savings Finance and Investment

• Savings depend upon propensity to save. It is the ability

by which claims to resources are set aside and become
available for some other purposes.
• Finance is the activity by which claims to resources
released through domestic savings , are placed in the
hands of investors.
• Investment: It is an activity by which resources are
actually committed to production.

9
Financial System- Institutional Arrangement

• The extent of savings and investment varies considerably amongst

different economic units.
• The economists have classified economic units into three categories
namely:
• i) Saving-Surplus Units
• ii) Saving Deficit Units and
• iii) Neutral Units. (Savings are equal to investments)
• If capital formation is to take place , savings of the saving surplus
units must be transferred to saving deficit units.
• Thus there is a need for institutional arrangement to facilitate
transfer of resources.
• This is precisely what financial systems do by acting as a link
between savers and investors.
• Financial System facilitates the flow of savings to industrial 10
investment.
Role of Financial System

Finance(link)
Savings Investment

Savers Supply of
Geographic Funds Investors
ally (Financers) (market
scattered, Demand information
Lack, Ability for Risk taking
and market Funds ability
information

11
Importance of Financial System
• Financial System is important in the process of capital formation
because
• 1) Act of investment is confined to special class of businessmen who
have got requisite technical and market information and
temperament (risk taking ability) to use it.
• 2) The activity of savings is diffused to innumerable individuals who
lack the skill, capacity and personal characteristics to for active
investment.
• 3) There are geographical and technical limitations that inhibit the
process of investment.
• This gap is filled in by Financial System which promote the process of
capital formation by bringing together the supply of savings and
demand for investible funds.
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Structure of the Indian Financial System

• The Financial System consists of

• 1) Savers
• 2) Investors
• 3) Financial Intermediaries (Institutions)
• 4) Financial Markets
• 5) Financial Instruments

13
Overview
Overview of Financial System

Financial
Savers Institutions Investors

Money

Financial
FinancialInstruments
MarketsFF
Financial Markets 14
Financial Institutions

15
Financial Intermediation

• Financial Institution act as intermediaries/links between

savers and investors.
• They collect savings from depositors and place it into the
hands of investors.
• They possess information about the market and also skill
to lend.
• In an efficient financial system the cost of intermediation
is small and speed is high.
• Efficiency of Financial Intermediation
• Cost
• Speed
• Accuracy 16
 Main Financial Intermediaries

• Main Financial Intermediaries

Non-
Banking Mutual Insurance
Banks
Financial Funds Companies
Companies

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Main Financial Intermediaries

• 1) Banks
• 2) Non Banking Financial Companies
• 3) Mutual funds
• 4) Insurance Companies

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Financial Institutions

Regulatory
(RBI,NABARD)

Intermediaries
Banks
Financial
Institutions Intermediaries
(Non-Banks)
UTI, Insurance companies

Non-Intermediaries
SIDBI 19
Financial Institutions-Types

• Financial Institutions are business organizations that act

as
• a) Mobilizers and depositories of savings and dispenser
of credit.
• b) They provide other Financial services to community.
• Financial Institutions can be classified as:
• i) Regulatory
• ii) Intermediaries
• iii) Non Intermediaries

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Financial Institutions

• i) Regulatory: The institutions which undertake regulatory and

supervisory functions . RBI,NABARD
• ii) Intermediaries and Non Intermediaries: Banking & Non- Banking
• Intermediaries intermediate between savers and investors. These
institutions mobilize savings as well as lend . Their liabilities are to
ultimate savers and their assets are from investors or borrowers.
• All banking institutions are intermediaries. Many Non-Banking
institutions also act as intermediaries. UTI,LIC,GIC are NBFCs.
• Non-Intermediaries are the institutions whose resources are not
obtained from directly from savers. SIDBI is non-intermediary
institution.

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Banking System

R.B.I. Supervision

Participate in payment mechanism

of the economy

Bank Deposits are major

Banking constituent of money supply
System

They create credit/money

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Banking System

• Banking companies-Major Functions

• 1) Participate in payment mechanism of the economy.

(provide transaction services)
• 2) Deposits constitute major portion of national money
supply.
• 3) Create deposit or credit which is money.
Banks are governed by Banking Regulation Act 1948.

23
Structure of Banking System in India
R.B.I. N.A.B.A.R.D.

Commercial Regional Cooperative

Banks Rural Banks Banks

Private Primary District

Public State
Sector Agriculture Central
Sector Banks Cooperative
Banks Credit cooperativ
Banks
Societies e Banks

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Structure of Banking System in India

• Banking System in India consists of commercial and

cooperative banks, RRBs .
• Commercial Banks are : Private Sector & Public sector
(Under supervision & control of RBI)
• Cooperative Banks have three tier structure:
(Under Supervision & Control of NABARD)
• Primary Agricultural Cooperative Societies: (PACS)
• District Central Cooperative Banks
• State Cooperative Banks
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Functions of Banks-Details
• Commercial Banks: These collect savings primarily in form of
deposits and traditionally finance working capital requirements of
corporates. Thus traditionally , banks collect short term funds and
lend for short term purposes.
• However in tune with the needs of economy or financial system
banks have entered into
• a) Term lending business particularly infrastructure.
• b) Capital Market
• c) Retail finance: Housing , Consumer etc.
• d) Agricultural finance and priority sector areas
• e) Medium and small enterprises.
• f) Export finance.
• In spite of this diversification, primary focus of commercial banks 26
continues to be working capital financing.
Non Banking Financial Companies

• Non-Banking Financial Companies: (NBFCs)

• They provide a variety of fund/asset based and non-fund based
advisory services . Most of their funds are raised in form of public
deposits ranging between one year to seven years of maturity.
Depending on nature and type of service provided they are
categorized into:
• Leasing Companies.
• Hire-Purchase and consumer finance companies.
• Venture Capital Funds
• Merchant Banking Organizations.
• Credit Rating Agencies.
• Factoring and Forfaiting organizations
• Stock Broking firms
• Depositories. 27
Mutual Funds

• Mutual Fund is a special type of investment institution which acts as

conduit for investment.
• It pools the savings of small investors in to a well diversified portfolio
of sound investment.
• Mutual Funds issue securities (known as units) to the investors
(known as unit holders) in accordance with the quantum of money
invested by them.
• The profit(or losses) are shared by the investors in proportion to the
investments.
• Mutual Funds have Sponsor, Trustees, Asset Management Company
and a custodian.
• Their performance is monitored by SEBI and have to comply with
SEBI regulations. 28
 Insurance Organizations

• Insurance Companies:
• These companies invest the savings of their policy holders. (insurance
premium)
• Promise the beneficiaries a specified sum at a later date (on maturity of
insurance policy) or
• Upon happening of a certain event. (i.e. death of a policy holder)
• Insurance companies offer protection against the risk.
• Insurance companies occupy crucial position amongst all savings
institutions since they are able to collect savings from innumerable
individuals.
• Insurance companies are under supervision of Insurance Regulatory and
Development Authority.(IRDA)
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Quiz-1
• 1) What are the constituents of Financial System?
• (Draw Block Diagram)
• 2) Who are the Savers? What are their characteristics?
• 3) Who are investors? What are their characteristics?
• 4) What is Financial intermediation? Which are major Financial
Intermediaries?
• 5) What is efficient Financial intermediation?
• 6) Classify following institutions as Regulatory , Intermediaries , Non-
Intermediaries or NBFCs
(RBI, IRDA, UTI, LIC, G.I.C., Commercial banks, SIDBI, Credit Rating
Agency, Leasing company, Post office)
7) Which institutions control the following?
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Cooperative Banks , RRBs , Commercial Banks , Insurance companies
Financial Markets

• Main constituents of Financial Markets Major Players

RBI,
Commercial
Money Market Banks

Financial Mutual Funds,

Market Insurance
companies, FIIs,
Individuals,
Capital Market
Government,
Corporates,
Banks

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Financial Markets

32
Financial Markets

• Financial Market perform a crucial function in savings-investment

process as facilitating organization.
• They are a link between savers and investors both as individual as
well as investor.
• Financial Markets are classified into
• 1) Money Market.
• 2) Capital Market.
• Money Market: It is a market for dealing in monetary assets of short
term nature ; generally of less than one year.
• It refers to that segment of financial market which enables the
raising of short term funds for meeting temporary shortages of cash
. In this market temporary deployment of excess funds is made for
earning returns. 33
• Major participants in this market are RBI and Commercial Banks.
Financial Markets-Money Market

• The main objectives of money market are to provide:

• 1) Equilibrating mechanism for evening out short term surpluses and
deficiencies.
• 2) Focal point of RBI (Central Bank) for intervention for influencing
liquidity in the economy.
• 3) Reasonable access to the users of short term funds to meet their
requirement at realistic cost.
• Money Market comprises number of interrelated sub-markets namely:
• Call Market
• Treasury Bills Markets.
• Commercial Bills Market
• Commercial Papers (CPs Market)
• Certificate of Deposits (CDs Market) 34
• Money Market Mutual Funds and REPO Market etc.
Financial Market-Capital Market

• Capital Market is a market for long term funds.

• Its focus is on financing investment.
• The main participants in Capital Market are:
• Mutual Funds, Insurance Companies, Foreign Institutional Investors
and Individuals.
• Capital Market has two segments:
• 1) Primary Market 2) Secondary Market.
• Primary Market: It is also called as New Issue Market. It deals with
those securities which were offered to investors for the first time.
• Capital formation occurs through New Issue Market as it supplies
additional funds to corporates directly.
• The New Issue Market does not have any organizational set up
located at a particular place . 35
Financial Markets-Participants

• Financial Markets are centers or arrangements that provide facilities

for buying and selling of
• Financial Services and Claim.
• Operators/Traders in the Financial Markets are:
• 1) Corporations
• 2) Financial Institutions
• 3) Governments
• 4) Individuals.
• Operators deal directly or through brokers.
• It may be through organized exchanges or off the exchanges.
• On demand and supply side of the market are brokers, dealers ,
borrowers , lenders savers, investors etc. These are interlinked by
36
contracts and communication net work and laws.
Role of Financial Intermediaries
(Financial Services)
• The Financial Intermediaries tailor the financial assets to the
requirements of savers-investors. They provide:
• 1) Convenience
• 2) Lower Risk
• 3) Expert Management and
• 4) Economies of Scale.
• Convenience: Financial Intermediaries convert securities into more
convenient vehicle for mobilization of savings , particularly small
savers. For ex. Minimum threshold limit for investment into primary
issues is Rs5000 whereas in case of Mutual Funds minimum
threshold limit is Rs1000. Another convenience is liquidity. The
redemption facility is available for unit holders of open ended
mutual funds. 37
Role of Financial Intermediaries
(Financial Services)

• Lower Risk: Indirect securities such as mutual funds have the merit
of exposing investors to lower risk as compared to primary securities
. This is mainly because of benefit of diversification which is
available even to small investors.
• Diversification reduces risk of capital depreciation and poor
dividends.
• Expert Management : Investors of Indirect securities(Mutual Funds)
get advantage of trained , experienced and specialized management
and a continuous supervision. Small investors do not themselves
have expertise neither they can hire the services of experts.
• Economies of Scale : Financial Intermediaries are continually in the
business of purchase and selling of securities. Thus economies of
scale are available to them. Such economies are not available to
individual investors. 38
Financial Instruments

39
Financial Instruments- Securities

• Financial Assets/Instruments or Securities represent

• Claims on stream of income and/or assets of another economic unit
• These are held as store of value and for return expected.
• of securities/financial assets to suit investment requirements of
various types of investors.
• Financial system promotes financial product innovation. The
maturity and sophistication of the financial system depends upon
the prevalence of variety
• Financial Assets are broadly categorized as:
• i) Direct
• ii) Indirect
• iii) Derivatives
40
Financial Instruments-Direct Securities

• as well as return of capital. Direct Securities: Main type of primary

securities are
• 1) Ordinary/Equity Shares.
• 2) Preference Shares
• 3) Debentures/Bonds
• Ordinary/Equity Shares: These are ownership securities and represent
risk capital. The owners of such securities bear the risk and they are
residual claimants on income and assets. They participate in the
management of the company.
• Debentures: It is a creditorship security. Their holders are entitled to pre
specified interest and first claim on the assets of the entity. These can
be secured/unsecured; convertible/non convertible in to equity shares.
• Preference shares: It is a hybrid security and has some features of both
equity and debentures . The holders of these securities have preference 41
over the equity holders in respect of fixed dividend
Financial Instruments- Indirect Securities

• Preference Shares: All preference shares are redeemable within 10

years. Companies issue convertible preference shares which
embrace both features of both equity as well as preference shares.
• They are converted to equity shares.
• Indirect Securities/Financial Assets: Indirect securities are financial
assets are issued by financial intermediaries such as units of mutual
funds , policies of insurance companies deposits of banks and so on .
• These are better suited to requirements of small investors .
• Pooling of funds by financial intermediaries leads to number of
direct and indirect benefits such as
• Expertise , Economies of scale, Convenience, Lowering of risk etc.
42
Financial Instruments- Derivatives

• Derivative is a product whose value is derived from value of

underlying. (asset, index, reference rate etc.)
• The underlying can be equity, forex or any other asset.
• Price of derivative is derived from price of underlying asset.
• Financial Markets by their very nature are marked by very high
degree of volatility arising out of fluctuation in prices of financial
assets or securities.
• Derivative instruments lock-in the asset prices. Thus they minimize
the impact of fluctuations in asset prices.
• Thus these act as instruments of risk management.
• Most commonly used derivative contracts are forwards , futures and
options.
43
Quiz-2

• 1)What are the main constituents of Financial Market?

• 2)Who are main participants in money market?
• 3) Who are main participants in Capital Market?
• 4)What are the advantages Financial Intermediaries offer
to the investors in the Financial Market?
• 5) Explain features of
• a) Shares b) Bonds c) Fixed Deposit receipt issued by
bank.

44
Quiz-Financial/Physical assets

• Which of the following is a Financial asset/Physical Asset?

• 1) Fixed deposit receipt issued by bank
• 2) Debenture
• 3) House property.
• 4) Gold
• 5) Gold bond
• 6) Bond issued by housing company.
• 7)Units of mutual Fund.
• 8) Building owned by mutual fund company
• 9) Life policy.
• 10) 10 Year Government bond. 45
Role of Financial Intermediaries in Economic Development

• Economic Development is indicated by

• Per Capita Gross Domestic Product
• Employment level
• Growth
• Inflation
• Health (Social indicator)
• Education (Social indicator)
• Income
• Income Distribution
• Wealth Distribution
• Poverty
• Other Social Indicators (Female literacy , M/F Ratio)
46
Role of Financial Intermediaries in Economic Development
Financial Development

• Indicators of Financial Development:

• 1)Developed financial Intermediary Institutions (Banks, NBFCs, Mutual
Funds, Insurance Companies)
• Important Indicators:
• Number of branches , Number of financial products, cost effective,
convenient etc.
• 2) Developed Financial Markets:
• Important Indicators:
• Finance Ratio: Ratio of total issues of primary and secondary claims to
national income.
• Financial Inter-Relation Ratio: Ratio of Financial Assets to Physical Assets
in the Economy.
• Proportion of Current Account Deficit financed by market related flows. 47
Characteristics of a Developed Financial System

• Developed Financial System

• 1) is fully integrated domestically as well as internationally.
• 2) has lower transaction cost and information cost.
• 3) private banking and not public sector banking is important. There
is little Government intervention in allocation of credit.
• 4) has very strong and effective system of supervision and regulation
• 5) is characterized by presence of very strong , active and large sized
non banking financial sector comprising
• stock market, debt market , insurance companies, pension funds ,
mutual funds etc.
• 6) is open to current account and capital account convertibility.

48
Economic basis of Financial Intermediation
Role of Financial Intermediation

• 1. Pooling the resources of small savers

• 2. Providing safekeeping, accounting, and payments
mechanisms for resources
• 3. Providing liquidity
• 4. Diversifying risk
• 5. Collecting and processing information

49
Economic basis of Financial Intermediation
Pooling the resources of small savers

• Many borrowers require large sums, while many savers offers small
sums. Without intermediaries, the borrower for a Rs100,000 would
have to find 100 people willing to lend Rs1000.
• That is hardly efficient.
• Banks pool many small deposits and use this to make large loans.
• Insurance companies collect and invest many small premiums in
order to pay fewer large claims. Mutual funds accept small
investment amounts and pool them to buy large stock and bond
portfolios. In each case, the intermediary must attract many savers,
so the soundness of the institution must be widely believed. This is
accomplished through federal insurance or credit ratings.
50
Economic basis of Financial Intermediation
Safekeeping, accounting, and payments mechanisms

• Role of Financial Intermediaries

• Safekeeping of money in accounts,

• Records of payments, deposits and withdrawals
• Use of debit/ATM cards and cheques
• Financial intermediaries do much more cheaply because
of economies of scale.
• Services are standardized and automated on a large scale,
so per unit transaction costs are minimized.

51
Economic basis of Financial Intermediation
Providing liquidity

• Liquidity refers to how easily and cheaply an asset can be converted

to a means of payment.
• Financial intermediaries make is easy to transform various assets
into a means of payment through ATMs, checking accounts, debit
cards, etc.
• Financial intermediaries have many short term outflows as well as
long term outflows and inflows.
• Banks have short term funds. Insurance companies have long term
funds.
• They make profit from the spread between long and short term
interest rates.
• Economies of scale allow intermediaries to do this at minimum cost. 52
Economic basis of Financial Intermediation
Diversifying risk

• Diversification is a powerful tool in minimizing risk, for a given level

of return.
• Financial intermediaries help investors diversify in ways they would
be unable to do on their own.
• Mutual funds pool the funds of many investors to purchase and
manage a stock portfolio so that investors achieve stock market
diversification for as little at Rs1000.
• If an investor were to purchase stocks directly, such diversification
would much more investment.
• Banks spread depositor funds over many types of loans, so the
default of any one loan does not put depositor funds in jeopardy.

53
Economic basis of Financial Intermediation
Collecting and processing information

• Financial intermediaries are experts at collecting and processing

information in order to accurately gauge the risk of various
investments and to price them accordingly.
• Individuals are not likely have to tools or know-how to do the same,
and certainly could not do so as cheaply as financial intermediaries
(once again, economies of scale are important here).
• This need to collect/process information comes from a fundamental
asymmetric information problem inherent in financial markets.

54