The Indian Financial soundofheaven.info - Ebook download as PDF File .pdf), Text File . txt) or read book online. PART B - (5 x 16 = 80 marks). (a). Describe the structure of the Indian Financial System. Or. (b). Elaborate the characteristics of Indian capital market. The financial system performs its basic activities through the components and involves. Chapter 1 The Indian Financial System. Solved Question Papers. INDIAN.
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Introduction to Indian Financial System. Significance and Definition. Purpose and Organisation. Liberalisation of the Financial System. 2. International Journal of Management and Social Sciences Research (IJMSSR) ISSN: 1 Volume 1, No. 1, October Indian Financial System. 1 | Indian Financial System. Dr.R.K. Sreekanth. FINANCIAL SYSTEM. Introduction. In its simple meaning the term 'finance' refers to monetary resources & the.
The instrument-wise analysis of financial flows reveals the aggregate preference pattern of various sectors for different financial instruments. Section I of the book is an introduction to the term financial system. Figures may not add up to the totals due to rounding off. A study of trends in saving and investment is necessary to evaluate this role. It is not merely a sum total of the value of all of the output but a sum total of value-added of output. RBI have taken follow up action, summed up below:
The advantages are: Due to these advantages, a wide range and higher rates of interest prevail in the informal sector. An interpenetration is found between the formal and informal systems in terms of operations, participants, and nature of activities which, in turn, have led to their coexistence. A high priority should be accorded to the development of an efficient formal financial system as it can offer lower intermediation costs and services to a wide base of savers and entrepreneurs.
The Indian financial system can also be broadly classified into the formal organised financial system and the informal unorganised financial system. The informal financial system consists of: Individual moneylenders such as neighbours, relatives, landlords, traders, and storeowners. Groups of persons operating as funds or associations.
These groups function under a system of their own rules and use names such as fixed fund, association, and saving club. Partnership firms consisting of local brokers, pawnbrokers, and non-bank financial intermediaries such as finance, investment, and chit-fund companies. In India, the spread of banking in rural areas has helped in enlarging the scope of the formal financial system. These are: These are intermediaries that mobilise savings and facilitate the allocation of funds in an efficient manner.
Financial institutions can be classified as banking and non-banking financial institutions. Banking institutions are creators and purveyors of credit while non-banking financial institutions are purveyors of credit. While the liabilities of banks are part of the money supply, this may not be true of non-banking financial institutions. In India, non-banking financial institutions, namely, the developmental financial institutions DFIs , and non-banking financial companies NBFCs as well as housing finance companies HFCs are the major institutional purveyors of credit.
In the post-reforms era, the role and nature of activity of these financial institutions have undergone a tremendous change. Banks have now undertaken non-bank activities and financial institutions have taken up banking functions. Most of the financial institutions now resort to financial markets for raising funds. 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. The main organised financial markets in India are the money market and the capital market.
The first is a market for short-term securities while the second is a market for long-term securities, i. Financial markets can also be classified as primary and secondary markets.
While the primary market deals with new issues, the secondary market is meant for trading in outstanding or existing securities. There are two components of the secondary market: The government securities market is an OTC market.
In an OTC market, spot trades are negotiated and traded for immediate delivery and payment while in the exchange-traded market, trading takes place over a trading cycle in stock exchanges. Recently, the derivatives market exchange traded has come into existence.
Financial instruments represent paper wealth shares, debentures, like bonds and notes. Many financial instruments are marketable as they are denominated in small amounts and traded in organised markets.
This distinct feature of financial instruments has enabled people to hold a portfolio of different financial assets which, in turn, helps in reducing. All-India Financial Institutions: Different types of financial instruments can be designed to suit the risk and return preferences of different classes of investors. Savings and investments are linked through a wide variety of complex financial instruments known as securities.
Securities are defined in the Securities Contracts Regulation Act SCRA , as including shares, scrips, stocks, bonds, debentures, debenture stocks or other marketable securities of a similar nature or of any incorporated company or body corporate, government securities, derivatives of securities, units of collective investment scheme, security receipts, interest and rights in securities, or any other instruments so declared by the central government. Financial securities are financial instruments that are negotiable and tradeable.
Financial securities may be primary or secondary securities. Primary securities are also termed as direct securities as they are directly issued by the ultimate borrowers of funds to the ultimate savers. Examples of primary or direct securities include equity shares and debentures.
Secondary securities are also referred to as indirect securities, as they are issued by the financial intermediaries to the ultimate savers. Bank deposits, mutual fund units, and insurance policies are secondary securities. Financial instruments differ in terms of marketability, liquidity, reversibility, type of options, return, risk, and transaction costs. Financial instruments help financial markets and financial intermediaries to perform the important role of channelising funds from lenders to borrowers.
Availability of different varieties of financial instruments helps financial intermediaries to improve their own risk management. These are those that help with borrowing and funding, lending and investing, buying and selling securities, making and enabling payments and settlements, and managing risk exposures in financial markets. The major categories of financial services are funds intermediation, payments mechanism, provision of liquidity, risk management, and financial engineering.
Funds intermediating services link the saver and borrower which, in turn, leads to capital formation. New channels of financial intermediation have come into existence as a result of information technology.
Payment services enable quick, safe, and convenient transfer of funds and settlement of transactions. Liquidity is essential for the smooth functioning of a financial system. Financial liquidity of financial claims is enhanced through trading in securities. Liquidity is provided by brokers who act as dealers by assisting sellers and buyers and also by market makers who provide buy and sell quotes. Financial services are necessary for the management of risk in the increasingly complex global economy.
They enable risk transfer and protection from risk. Risk can be defined as a chance of loss. Risk transfer of services help the financial market participants to move unwanted risks to others who will accept it. The speculators who take on the risk need a trading platform to transfer this risk to other speculators. In addition, market participants need financial insurance to protect themselves from various types of risks such as interest rate fluctuations and exchange rate risk.
Growing competition and advances in communication and technology have forced firms to look for innovative ways for value creation. Financial engineering presents opportunities for value creation. These services refer to the process of designing, developing, and implementing innovative solutions for unique needs in funding, investing, and risk management. The producers of these financial services are financial intermediaries, such as, banks, insurance companies, mutual funds, and stock exchanges.
Financial intermediaries provide key financial services such as merchant banking, leasing, hire purchase, and credit-rating. Financial services rendered by the financial intermediaries bridge the gap between lack of knowledge on the part of investors and the increasing sophistication of financial instruments and markets.
These financial services are vital for creation of firms, industrial expansion, and economic growth. Before investors lend money, they need to be reassured that it is safe to exchange securities for funds. The financial regulator who regulates the conduct of the market and intermediaries to protect the investors interests provides this reassurance.
The regulator regulates the conduct of issuers of securities and the intermediaries to protect the interests of investors in securities and increases their confidence in markets which, in turn, helps in the growth and development of the financial system. Regulation is necessary not only to develop a system, but a system once developed needs to be regulated.
The securities market is regulated. A high-level committee on capital and financial markets coordinates the activities of these agencies. Interaction Among Financial System Components The four financial system components discussed do not function in isolation.
They are interdependent and interact continuously with each other. Their interaction leads to the development of a smoothly functioning financial system. Financial institutions or intermediaries mobilise savings by issuing different types of financial instruments which are traded in the financial markets. To facilitate the credit-allocation process, these institutions acquire specialisation and render specialised financial services.
Financial intermediaries have close links with the financial markets in the economy. Financial institutions acquire, hold, and trade financial securities which not only help in the creditallocation process but also make the financial markets larger, more liquid, stable, and diversified. Financial intermediaries rely on financial markets to raise funds whenever the need arises. This increases the competition between financial markets and financial intermediaries for attracting investors and borrowers.
The development of new sophisticated markets has led to the development of complex securities and portfolios. The evaluation of these complex securities, portfolios, and strategies requires financial expertise which financial intermediaries provide through financial services.
Financial markets have also made an impact on the functioning of financial intermediaries such as banks and financial institutions. The latter are, today, radically changed entities as the bulk of the service fees and non-interest income that they derive is directly or indirectly linked to financial market-related activities. Moreover, liquid and broad markets make financial instruments a more attractive avenue for savings, and financial services may encourage further savings if the net returns to investors are raised or increased.
By acting as an efficient conduit for allocation of resources, it permits continuous upgradation of technologies for promoting growth on a sustained basis. A financial system not only helps in selecting projects to be funded but also inspires the operators to monitor the performance of the investment. Financial markets and institutions help to monitor corporate performance and exert corporate control through the threat of hostile takeovers for underperforming firms.
It provides a payment mechanism for the exchange of goods and services and transfers economic resources through time and across geographic regions and industries. Payment and settlement systems play an important role to ensure that funds move safely, quickly, and in a timely manner.
An efficient payment and settlement system contributes to the operating and allocation efficiencies of the financial system and thus, overall economic growth. Payment and settlement systems serve an important role in the economy as the main arteries of the financial sector. Banks provide this mechanism by offering a means of payment facility based upon cheques, promissory notes, credit and debit cards. This payment mechanism is now increasingly through electronic means.
The clearing and settlements mechanism of the stock markets is done through depositories and clearing corporations. One of the most important functions of a financial system is to achieve optimum allocation of risk bearing. It limits, pools, and trades the risks involved in mobilising savings and allocating credit.
An efficient financial system aims at containing risk within acceptable limits. It reduces risk by laying down rules governing the operation of the system. Risk reduction is achieved by holding diversified portfolios and screening of borrowers. Market participants gain protection from unexpected losses by buying financial insurance services. Risk is traded in the financial markets through financial instruments such as derivatives.
Derivatives are risk shifting devices, they shift risk from those who have it but may not want it to those who are willing to take it.
A financial system also makes available price-related information which is a valuable assistance to those who need to take economic and financial decisions. Financial markets disseminate information for enabling participants to develop an informed opinion about investment, disinvestment, reinvestment,.
Functions of a Financial System Mobilise and allocate savings Monitor corporate performance Provide payment and settlement systems Optimum allocation of risk-bearing and reduction Disseminate pricerelated information Offer portfolio adjustment facility Lower the cost of transactions Promote the process of financial deepening and broadening. This information dissemination enables a quick valuation of financial assets. Moreover, by influencing the market price of a firms debt and equity instruments, this process of valuation guides the management as to whether their actions are consistent with the objective of shareholder wealth maximisation.
In addition, a financial system also minimises situations where the information is asymmetric and likely to affect motivations among operators when one party has the information and the other party does not. It also reduces the cost of gathering and analysing information to assist operators in taking decisions carefully. A financial system also offers portfolio adjustment facilities. These are provided by financial markets and financial intermediaries such as banks and mutual funds.
Portfolio adjustment facilities include services of providing a quick, cheap and reliable way of buying and selling a wide variety of financial assets. A financial system helps in the creation of a financial structure that lowers the cost of transactions. This has a beneficial influence on the rate of return to savers. It also reduces the cost of borrowing. Thus, the system generates an impulse among the people to save more.
A well-functioning financial system helps in promoting the process of financial deepening and broadening. Financial depth is an important measure of financial system development as it measures the size of the financial intermediary sector.
Depth equals the liquid liabilities of the financial system currency plus demand and interest-bearing liabilities of banks and non-bank financial intermediaries divided by the GDP. Financial broadening refers to building an increasing number and variety of participants and instruments.
The basic elements of a well-functioning financial system are i a strong legal and regulatory environment, ii stable money, iii sound public finances and public debt management, iv a central bank, v a sound banking system, vi an information system, and vii a well-functioning securities market. Since finance is based on contracts, strong legal and regulatory systems that produce and strictly enforce laws alone can protect the rights and interests of investors. Hence, a strong legal system is the most fundamental element of a sound financial system.
Stable money is an important constituent as it serves as a medium of exchange, a store of value a reserve of future purchasing power , and a standard of value unit of account for all the goods and services we might wish to trade in. Large fluctuations and depreciation in the value of money lead to financial crises and impede the growth of the economy. Sound public finance includes setting and controlling public expenditure priorities and raising revenues adequate to fund them efficiently.
Historically, these financing needs of the governments world over led to the creation of financial systems. Developed countries have sound public finances and public debt management practices, which result in the development of a good financial system.
A central bank supervises and regulates the operations of the banking system. It acts as a banker to the banks, banker to the government, manager of public debt and foreign exchange, and lender of the last resort. The monetary policy of the central bank influences the pace of economic growth.
An autonomous central bank paves the way for the development of a sound financial system. A good financial system must also have a variety of banks both with domestic and international operations together with an ability to withstand adverse shocks without failing.
Banks are the core financial intermediaries in all countries. They perform diverse key functions such as operating the clearing and payments system, and the foreign exchange market. The banking system is the main fulcrum for transmitting the monetary policy actions. Banks also undertake credit risk analysis, assessing the expected risk and return on the projects. The financial soundness of the banking system depends on how effectively banks perform these diverse functions.
Another foundational element is information. All the participants in a financial system require information. A sound financial system can develop only when proper disclosure practices and networking of information systems are adopted.
Securities markets facilitate the issue and trading of securities, both equity and debt. Efficient securities markets promote economic growth by mobilising and deploying funds into productive uses, lowering the cost of capital for firms, enhancing liquidity, and attracting foreign investment. An efficient securities market strengthens market discipline by exerting corporate control through the threat of hostile takeovers for underperforming firms.
Different designs of financial systems are found in different countries. The structure of the economy, its pattern of evolution, and political, technical, and cultural differences affect the design type of financial system. Two prominent polar designs can be identified among the variety that exists. At one extreme is the bank-dominated system, such as in Germany, where a few large banks play a dominant role and the stock market is not important.
At the other extreme is the market-dominated financial system, as in the US, where financial markets play an important role while the banking industry is much less concentrated. The other major industrial countries fall in between these two extremes Figure 1. Demirguc Kunt and Levine have provided explanations of bank-based and market-based financial systems. In bank-based financial systems, banks play a pivotal role in mobilising savings, allocating capital, overseeing the investment decisions of corporate managers, and providing riskmanagement facilities.
In market-based financial systems, the securities markets share centre stage with banks in mobilising the societys savings for firms, exerting corporate control, and easing risk management.
Bank-based systems tend to be stronger in countries where governments have a direct hand in industrial development. In India, banks have traditionally been the dominant entities of financial intermediation.
The nationalisation of banks, an administered interest rate regime, and the government policy of favouring banks led to the predominance of a bank-based financial system.
Demirguc Kunt and Levine, using a database of countries, have classified countries according to the structure and level of financial development Table 1. Demirguc Kunt, A. Levine , Bank-based and Market-based Financial System: Their comparison of financial systems across different income groups reveals several patterns.
First, financial systems are, on an average, more developed in rich countries. There is a tendency for a financial system to become more market-oriented as the country becomes richer.
Second, countries with a common-law tradition, strong protection of shareholders rights, and low levels of corruption tend to be more market-based and have well-developed financial systems. Arnold and Walz have attempted to identify factors leading to the emergence of bank-based or market-based financial systems. When problems relating to information persist but banks are competent. Bank-based Financial System Advantages Close relationship with parties Provides tailor-made contracts Efficient intertemporal risk-sharing No free-rider problem Drawbacks Retards innovation and growth Impedes competition.
Conversely, if banks are initially incompetent and fail to improve themselves by experience, the bank-based system gives way to the growth of a marketbased financial system. Given these two types of financial systems, questions arise about the advantages and disadvantages of a bank-based financial system vis-a-vis a market-based financial system. Some researchers suggest that markets are more effective at providing financial services while some tout the advantages of intermediaries. Proponents of the market-based view argue that efficiency is associated with the functioning of competitive markets.
Financial markets are attractive as they provide the best terms to both investors and borrowers. Stock markets facilitate diversification and allow efficient risk-sharing. They provide incentives to gather information that is reflected in stock prices and these prices, in turn, provide signals for an efficient allocation of investment.
An important area in which financial markets perform differently from financial intermediaries is in situations where a diversity of opinion is important, such as the financing of new technologies or when an unusual decision has to be made. Hence, in emerging industries with significant financial and technological risks, a market-based system may be preferable. The drawbacks of the market-based system are that it is more prone to instability, its investors are exposed to market risks, and that there is a free-rider problem.
The last drawback arises when no individual is willing to contribute towards the cost of something but hopes that someone else will bear the cost. This problem arises whenever there is a public good and separation of ownership from control. For example, shareholders take little interest in the management of their companies, hoping someone else will monitor the executives. In a market-based system, the free-rider problem blunts the incentives to gather information.
On the other hand, a bank-based system is perceived to be more stable, as the relationship with parties is relatively close. This leads to the formation of tailor-made contracts and financial products and efficient inter-temporal risk-sharing.
Financial intermediaries can eliminate the risks that cannot be diversified at a given point of time but can be averaged over time through inter-temporal smoothing of asset returns. This requires that investors accept lower returns than what the market offers in some periods in order to get higher returns in other periods.
This provides an insurance to investors who would otherwise be forced to liquidate assets at disadvantageous prices. The banking system avoids some of the information deficiencies associated with the securities markets. The free-rider problem is eliminated as private incentives to gather information are higher in the case of a bank-based system. Moreover, banks can perform screening and monitoring functions on behalf of the investors; these functions, left to themselves, can be undertaken only at a high cost.
The greatest drawback of a bank-based system is that it retards innovation and growth as banks have an inherent preference for low-risk, low-return projects. Moreover, powerful banks may collude with firm managers against other investors, which, in some cases, could impede competition, effective corporate control, and entry of new firms.
The current trend is a preference for the market-based system. France and Japan have reformed their markets to make them more competitive. It is partly due to the growing volume of banking activity in the financial markets. The European Union is moving towards a single unified market to increase its global competitiveness.
In India also, the role of stock markets has gained prominence. The government has put in substantial efforts to reform the financial markets. The Indian equity market, now, is at par with some of the developed markets of the world. Moreover, the ratio of market capitalisation to. In the s and s, Gurley and Shaw , , and Goldsmith discussed the stages in the evolution of financial systems. According to them, there is a link between per capita income and the development of a financial system.
At low levels of development, most investment is self-financed and financial intermediaries do not exist, as the costs of financial intermediation are high relative to benefits.
As countries develop and per capita income increases, bilateral borrowing and lending take place leading to the birth of financial intermediaries. The number of financial intermediaries grows with further increases in per capita income. Among the financial intermediaries, banks tend to become larger and prominent in financial investment. As countries expand economically, non-bank financial intermediaries and stock markets grow in size and tend to become more active and efficient relative to banks.
There is a general tendency for financial systems to become more market-oriented as countries become richer. The relative share of banks in the aggregate financial assets of banks and financial institutions taken together, which stood at nearly three-fourths in the early s, is now hovering around the two-thirds mark since the s. This implies that there is considerable potential for growth in market financing. Allen and Gale have put forward two explanations for the universal popularity of financial markets: Empiral analysis in various researches do not emphatically suggest the superiority of one system over the other.
Whatever be the type of financial system, both financial intermediaries and financial markets play a crucial role in the development of a sound financial system. Both systems can coexist as they encourage competition, reduce transaction costs, and improve resource allocation within the economy, leading to the development of a balanced financial system. Good financial institutions are vital to the functioning of an economy. If finance were to be described as the circulatory system of the economy, financial institutions are its brain.
They make decisions that tell scarce capital where to go and ensure that it is used most efficiently. It has been confirmed by research that countries with developed financial institutions grow faster and countries with weak ones are more likely to undergo financial crises. Lenders and borrowers differ in regard to terms of risk, return, and terms of maturity. Financial institutions assist in resolving this conflict between lenders and borrowers by offering claims against themselves and, in turn, acquiring claims on the borrowers.
The former claims are referred to as indirect secondary securities and the latter as direct primary securities. Financial institutions provide three transformation services:. Liability, asset, and size transformation consisting of mobilisation of funds, and their allocation by providing large loans on the basis of numerous small deposits.
Maturity transformation by offering the savers tailor-made short-term claims or liquid deposits and so offering borrowers long-term loans matching the cash-flows generated by their investment. Risk transformation by transforming and reducing the risk involved in direct lending by acquiring diversified portfolios. Through these services, financial institutions are able to tap savings that are unlikely to be acceptable otherwise.
Moreover, by facilitating the availability of finance, financial institutions enable the consumer to spend in anticipation of income and the entrepreneur to acquire physical capital. The role of financial institutions has undergone a tremendous transformation in the s. Besides providing direct loans, many financial institutions have diversified themselves into areas of financial services such as merchant banking, underwriting and issuing guarantees.
Financial Markets. Financial Markets Financial markets are an important component of the financial system. They are a mechanism for the exchange trading of financial products under a policy framework. The participants in the financial markets are the borrowers issuers of securities , lenders buyers of securities , and financial intermediaries. Financial markets comprise two distinct types of markets: It is a highly liquid market wherein securities are bought and sold in large denominations to reduce transaction costs.
Types Money Marketa market for short-term debt instruments Capital Marketa market for long-term equity and debt instruments Segments Primarya market for new issues Secondarya market for trading outstanding issues. The functions of a money market are to serve as an equilibrating force that redistributes cash balances in accordance with the liquidity needs of the participants; to form a basis for the management of liquidity and money in the economy by monetary authorities; and to provide reasonable access to the users of short-term money for meeting their requirements at realistic prices.
As it facilitates the conduct of monetary policy, a money market constitutes a very important segment of the financial system. Capital Market A capital market is a market for long-term securities equity and debt. The purpose of capital market is to. Money Market and Capital Market There is strong link between the money market and the capital market: Often, financial institutions actively involved in the capital market are also involved in the money market.
Funds raised in the money market are used to provide liquidity for long-term investment and redemption of funds raised in the capital market. In the development process of financial markets, the development of the money market typically precedes the development of the capital market.
A capital market can be further classified into primary and secondary markets. The primary market is meant for new issues and the secondary market is one where outstanding issues are traded. In other words, the primary market creates long-term instruments for borrowings, whereas the secondary market provides liquidity through the marketability of these instruments. The secondary market is also known as the stock market.
Link Between the Primary and the Secondary Capital Market A buoyant secondary market is indispensable for the presence of a vibrant primary capital 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. Primary Capital Market and Secondary Capital Market Even though the secondary market is many times larger than the primary market, they are interdependent in many ways.
The primary market is a market for new issues, but the volume, pricing, and timing of new issues are influenced by returns in the stock market. Returns in the stock market depend on macroeconomic factors. Favourable macroeconomic factors help firms earn higher returns, which, in turn, create favourable conditions for the secondary market. This in turn, influences the market price of the stock. Moreover, favourable macroeconomic factors necessitate raising fresh capital to finance new projects, expansion, and modernisation of existing projects.
A buoyant secondary market, in turn, induces investors to buy new issues if they think that is a good decision. Hence, a buoyant secondary market is indispensable for the presence of a vibrant primary capital market. The secondary market provides a basis for the determination of prices at which new issues can be offered in the primary market.
The depth of the secondary capital market depends upon the activities in the primary market because the bigger the entry of corporate entities, the larger the number of instruments available for trading in the secondary market.
The secondary market volume surge in was part driven by a rampant primary market, as newly listed stocks tend to have a high turnover. New issues of a large size and bunching of large issues may divert funds from the secondary market to the primary market, thereby affecting stock prices. Characteristics of Financial Markets Financial markets are characterised by a large volume of transactions and the speed with which financial resources move from one market to another.
There are various segments of financial markets such as stock markets, bond marketsprimary and secondary segments, where savers themselves decide when and where they should invest money. There is scope for instant arbitrage among various markets and types of instruments.
Financial markets are highly volatile and susceptible to panic and distress selling as the behaviour of a limited group of operators can get generalised. Markets are dominated by financial intermediaries who take investment decisions as well as risks on behalf of their depositors. Negative externalities are associated with financial markets. A failure in any one segment of these markets may affect other segments, including non-financial markets.
Domestic financial markets are getting integrated with worldwide financial markets. The failure and vulnerability in a particular domestic market can have international ramifications. Similarly, problems in external markets can affect the functioning of domestic markets.
In view of the above characteristics, financial markets need to be closely monitored and supervised. Functions of Financial Markets The cost of acquiring information and making transactions creates incentives for the emergence of financial markets and institutions.
Different types and combinations of information and transaction costs motivate distinct financial contracts, instruments and institutions. Financial markets perform various functions such as. This spurs investors to make inquiries themselves and keep track of the companies activities with a view to trading in their stock efficiently; transmutation or transformation of financial claims to suit the preferences of both savers and borrowers; enhancing liquidity of financial claims through trading in securities; and providing portfolio management services.
A variety of services are provided by financial markets as they can alter the rate of economic growth by altering the quality of these services. The financial systems of most developing countries are characterised by coexistence and co-operation between the formal and informal financial sectors. Formal financial systems consist of four segments or components: Financial institutions are intermediaries that mobilise savings and facilitate the allocation of funds in an efficient manner.
Financial institutions can be classified into banking and non-banking, term finance, specialised, sectoral, investment, and state-level. Financial markets are also classified as primary and secondary markets. While the primary market deals in new issues, the secondary market is meant for trading in outstanding or existing securities. Financial services are those that help with borrowing and funding, lending and investing, buying and selling securities, making and enabling payments and settlements, and managing risk exposures in financial markets.
The four sub-systems do not function in isolation. The functions of a financial system include mobilising and allocating savings, monitoring corporate performance, providing payment and settlement systems, optimum allocation of risk-bearing and reduction, disseminating price-related information, offering portfolio adjustment facility, lowering the cost of transactions, and promoting the process of financial deepening and broadening.
The basic elements of a well-functioning financial system are i a strong legal and regulatory environment, ii stable money, iii sound public finances and public debt management, iv central bank, v a sound banking system vi an information system, and vii a well-functioning securities market. The two types of financial system designs are: At one extreme is the bank-dominated system, such as in Germany, where a few large banks play a dominant role and the stock market is not that important.
At the other extreme, is the market-dominated financial system, as in the US, where financial markets play an important role while the banking industry is much less concentrated.
What is a financial system? Discuss the components of a formal financial system. Discuss the types of financial markets and their inter-relationship.
What are the characteristics and functions of financial markets? A market-based financial system is preferable over a bank-based system. Comment critically.
A financial system is a well-integrated system whose parts interact with each other. Arnold, L. Bencivenga, Valerie R. Bhole, L. Levine , Bank-based and Marketbased Financial Systems: International Financial Corporation , Financial Institutions: Neave, Edwin , Financial Systems: Principles and Organisation, Routledge, London. Robinson, R. Rousseau, Peter L. Shaw, G. The Economic Journal, vol. Singh, Ajit and B. Stigilitz, J.
Bruno and B. Pleskoviz eds. All economies operate with a stock of real and financial assets. Real assets may be tangible or intangible. Examples of tangible real assets are land and natural resources, buildings, inventories, equipment, durables, and infrastructure. Examples of intangible real assets are human capital, organisational systems, and governments. Every asset represents savings either by the owner himself or by lenders of surplus savings.
Most of the real assets are financed through borrowings suppliers of surplus savings.
Financial assets, or claims, or securities, or instruments come into existence to enable transfer of savings for investment. Financial assets may be classified as equity instruments, debt instruments, deposits, units, and insurance policies. In a modern market economy, the real and financial assets must interact for the process of capital formation to take place.
In any economy, there are two types of economic units or entitiessurplus-spending economic units and deficit-spending economic units. Surplus-spending Economic Units These are units whose consumption and planned investment are less than their income. The surplus savings that they have is held in the form of cash balances or financial assets. The acquisition of financial assets or making of loans is, in fact, lending for productive investment.
Such lending by the surplus-spending sector can be termed as demanding financial assets or supplying loanable funds. In India, the household sector is a net-surplus spending economic unit.
The household and other sectors are discussed in detail in the flow of funds analysis. Types of Economic Units Surplus-spending economic units: Deficit-spending Economic Units These are units whose consumption and planned investment exceeds income. The deficit-spending economic units have negative savings; they finance their needs by borrowing or by decreasing their stock of financial assets. Borrowing by deficit-spending units creates a supply of financial securities or demand for loanable funds.
In India, the government and the corporate sector are deficit-spending economic units. The surplus savings of the surplus-spending household units have to be transferred to the deficit-spending economic units. A link in the form of a financial system is necessary to transfer surplus savings to deficit units. The surplus and deficit units can be brought together either directly through external financing or indirectly through intermediation banks and other financial institutions.
Figure 2. Financial intermediaries issue secondary securities like deposits, insurance policies, and units to the ultimate lenders. The ultimate borrowers may acquire funds either by issuing primary securities to financial intermediaries or by issuing primary securities in the financial markets. This transfer of funds from the surplus-spending sector to the deficit-spending sector through the financial system leads to capital formation and economic growth. Economic growth, in simple terms, is the increase in the real national product or output over time.
Besides linking savings and investment, the financial system helps in accelerating the rate of savings and investment by offering diversified financial services and instruments. This promotes a larger production of goods and services in the economy, leading to economic growth. The pace of achievement of broader national objectives depends on the efficiency of the financial system. To understand the role of the financial system in the economy, some frameworks and concepts of macroeconomics are deployed.
The main tools of analysis are as follows. National Income Accounts National income accounts extend the accounting concept to the economy as a whole. National income accounts of the sector-of-origin reveal the contribution made by different sectors of the economy to the national income and the portion of the national income they consume.
Flow of Funds Accounts The savings and investment process creates a flow of funds among sectors. Moreover, many transactions in the economy that are not included in the national income accounts take place as well. Hence, an analysis of the flow of funds accounts becomes necessary. Flow of funds brings out patterns of financing economic activities and the financial relations among various sectors of the economy.
The national income accounts are combined with the flow of funds accounts to form a framework for describing the transfer of funds and supply and demand in the securities market. This framework helps to grasp the savinginvestment process in the economy, essential for comprehending the working of the financial system. Trends in Saving and Investment One of the basic influences of financial development on growth is the saving and investment rate.
Among the many roles of the financial system is the augmenting and channelising of savings into productive avenues for economic growth. A study of trends in saving and investment is necessary to evaluate this role. National Income Accounts Use: To measure production in the economy and earnings derived from production.
It is used to measure production in the economy and earnings derived from production. Both national income and product are flow concepts and are measured over a given or specified period of time. National product refers to the flow of goods and services produced by the residents of a country during any given period of time.
National income represents the flow of total factor earnings available for purchasing the net flow of goods and services in the economy during any given period of time. The data furnished by the national income accounts can be put to a variety of uses. The annual series on the economys national income classified by industry-of-origin provides useful information about the structure of the economy. National income accounts classified by sector-of-origin show what kind of income has been generated in each sector of the economy and the total value of the goods and services produced by each sector.
The base year has been shifted four times: Classification of the Indian Economy The Indian economy is classified into the following industrial sectors: Primary sector: The GDP is a broad measure of the output of goods and services in an economy. It is not merely a sum total of the value of all of the output but a sum total of value-added of output. There are two ways in which the GDP can be measured.
It can be measured at the production stage or as the sum total of consumption. Both the methods should yield the same result. When measured from the production side, the GDP is broadly divided with three sectors: In measuring output from the consumption side, the GDP is equal to the sum of private consumption, government consumption, investment and net exports.
The GDP at market price is inclusive of the indirect taxes levied by the government and profits.
The GDP takes into account only what is produced within the country. The Gross National Product GNP at factor cost is arrived at by adding foreign income such as repatriated income, profits and loyalties from abroad to the GDP at factor cost. It is simply the GNP adjusted for depreciation charges. The NNP gives an idea of the net increase in the total production of the country. It is helpful in the analysis of the long-run problem of maintaining and increasing the supply of physical capital in the country.
An analysis of Table 2. The industrial and service sectors experienced high growth rates in the s while agriculture registered a low growth rate in comparison with the s. This reflects a major structural shift in the Indian economy in the s wherein economic growth has become less vulnerable to agricultural performance and to the vagaries of the monsoon.
The GDP is not merely a sum total of the value of all of the output but a sum total of value-added of the output. There are two ways in which GDP can be measured.
When measured from the production side, GDP is broadly divided with three sectors; agriculture, industry and services. In measuring output from the consumption side, GDP is equal to the sum of private consumption, government consumption, investment and net exports.
The GDP at factor cost by economic activity is adjusted by adding indirect taxes net of subsidies to arrive at the estimated GDP at market prices, so that it equals the expenditure on gross domestic product. Gross capital formation refers to the aggregate of gross additions to fixed assets fixed capital formation , increase in stocks and inventories, or change in stocks and valuables. Gross fixed capital formation GFCF comprises two main components: The GFCF from machinery and equipment includes the ex-factory value of capital goods produced in the registered and unregistered manufacturing sectors and the excise duties paid on them, net imports of capital goods and TTMs, software production, fixed assets in livestock and installation charges of wind energy systems.
Figures in the brackets are periodwise sectoral composition. Advance estimates. Central Statistical Organization. There was a marked difference in the sectoral composition of growth within the industrial sector. This indicates an increase in finance-related activities and financial intermediation. India recorded one of the highest growth rates in the world: A rebound in agriculture, increased investment and output in the manufacturing sector, a turnaround in electricity generation, buoyant software exports, and growth in new economy services such as trade, hotels, transport and communication contributed to this increase in the GDP.
Competition, fall in interest rates, better infrastructure facilities and a growth in exports led to a manufacturing boom and made manufacturing grow faster than services. The Indian economy is on a growth trajectory of 8 per cent since four years in a row to Investment led growth in the manufacturing and services sectors, coupled with comfortable foreign exchange reserves and a robust increase in exports continued till The pace of GDP growth rate slowed down in on account of the decelerating growth in the industrial sector, international price increases in oil and commodity prices, increasing inflation, increasing cost of funds, moderating capital inflows and depreciation in the rupee against the dollar.
We can sustain this GDP growth rate by enhancing growth in all the three sectors. One of the basic indicators of financial development of an economy is the contribution of financerelated activities towards the GDP, i. The share of banking and insurance in the real GDP rose steadily from 2. Within the services sector also its share rose from 5. Higher growth rate of the GDP was, to some extent, due to an upsurge in financial intermediation activities. The increased contribution of banking and finance in the real GDP reflects the importance of financial intermediation activities in the economy.
With the help of this data, surplus and deficit sectors can be identified but it does not provide information on issues such as inter-sectoral fund flows, linkages and instruments. For this the national. While the shares from through are calculated with respect to the GDP as base, the same from through are with respect to as a base.
III-2 , and The flow of funds accounts reflect the diversified savings and investment flows from the broad sectors of an economy through various credit and capital market instruments.
In other words, the accounts bring out the pattern of financing economic activities and the financial inter-relationship among various sectors of the economy. The flow of funds accounts are essential for any comprehensive analysis of financial market behaviour. They help identify the role of finance in the generation of income, savings, and expenditure.
They also help identify the influence of economic activities on financial markets. A temporal and cross-section comparison of these accounts provides an insight into the changing pattern and degree of development in the process of intermediation. The channel through which savings find a way into the investment sectors is highlighted through these accounts. The volume of financial flows with respect to the index of economic activities, say the GNP, the NNP, or capital formation, provides a reliable indicator of the growing use of financial instruments.
The flow of funds accounts are also employed as an important tool for financial planning and forecasting. By utilising historical flow of funds, emerging trends in the economy and changes in financial patterns can be tracked.
This, in turn, can help in forecasting the flow of funds for the economy for a coming period of time. In short, they are very useful in understanding the financial institution structure, assets structure, financial inter-relationships, and the nature of financial development in the country.
The flow of funds accounts disclose the level, depth, and nature of financial activities in the economy. They are organised along two dimensionseconomic sectors and financial instrumentsto provide information on sector-wise and instrument-wise financial flows.
The flow of funds accounts for the Indian economy provide information on the following six sectorshouseholds, private corporate business sector, banking, other financial institutions, government, and the rest of the world RoW. These sectors participate in the financial activities through borrowing issuing claims on themselves and lending accepting claims on others. If the borrowing exceeds the lending, the sector is termed as a deficit sector; in the reverse case, it is a surplus sector.
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