Financial SystemsIntroductionIn its simple meaning the term ‘finance’ refers to monetary resources & the term ‘financing’ refers to the activity of providing required monetary resources to the needy persons and institutions. The term ‘financial system’ refers to a system that is concerned with the mobilization of the savings of the public and providing of necessary funds to the needy persons and institutions for enabling the production of goods and/or for provision of services. Thus, a financial system can be understood as a system that allows the exchange of funds between lenders, investors, and borrowers. In other words, the system that facilitates the movement of finance from the persons who have surplus funds to the persons who need it is called as financial system. It consists of complex, closely related services, markets, and institutions used to provide an efficient and regular linkage between investors and depositors. Financial systems operate at national, global, and firm-specific levels. It includes the public, private and government spaces and financial instruments which can relate to countless assets and liabilities. Components of Financial System 1. Financial Assets 2. Financial Intermediaries/Financial Institutions 3. Financial Markets 4. Financial Rates of Return 5. Financial Instruments Functions of Financial System 1. Provision of liquidity 2. Mobilization of savings 3. Size transformation/Capital formation 4. Maturity transformation 5. Risk transformation 6. Lowering of cost of transaction 7. Payment mechanism 8. Assisting new projects 9. Enable better decision making 10. Meet short and long term financial needs 11. Provide necessary finance to the Government 12. Accelerate the process of economic growth of the country Characteristics of Financial System 1. Financial system acts as a bridge between savers and borrowers 2. It consists of a set of inter-related activities and services 3. It consists of both formal and informal financial sectors. The existence of both formal and informal system is also called as financial dualism. 4. It formulates capital, investment and profit generation 5. It is universally applicable at firm level, regional level, national level and international level 6. It consists of financial institutions, financial markets, financial services, financial instruments, financial practices and financial transactions. FINANCIAL ASSETS Financial assets refer to the cash or cash equivalents that are used for production or consumption or for further creation of assets. Cash, Bank Deposits, Shares, Debentures, Investment in Gold, Land & Buildings, Contractual right to receive cash or another financial asset, etc., are called as financial assets. Classification of Financial Assets Financial assets are classified in two ways 1. On the basis of marketability 2. On the basis of nature Classification of Financial Assets On the basis of marketability 1. Marketable – The financial assets that can be bought and sold are called as marketable financial assets. They include Shares, Government Securities, Bonds, Mutual Funds, Units of UTI, Bearer Debentures 2. Non-marketable – The financial assets that cannot be bought and sold are called as nonmarketable finance assets. They include Bank Deposits, Provident Funds, LIC Policies, Company Deposits, Post Office Certificates Classification of Financial Assets on the basis of nature 1. Money or Cash Asset – Coins, Currency Notes, Bank Deposits 2. Debt Asset – Debenture & Bonds 3. Stock Asset – Equity Shares & Preference Shares FINANCIAL INTERMEDIARIES/FINANCIAL INSTITUTIONS Different kinds of organizations/institutions which intermediate and facilitate financial transactions of both individual and corporate customers are called as financial intermediaries or financial institutions. Basically they are classified into two types: 1. Unorganized Sector 2. Organized Sector Unorganized Sector The sector that is not governed by any statutory or legal authority is known as unorganized sector. This sector consists of the individuals and institutions for whom there are no standardized rules and regulations governing their financial dealings. They are not under the supervision and control of RBI or any other regulatory body. This sector consists of the individuals and institutions like Local money lenders, Pawn brokers, Traders, Landlords, Indigenous bankers, etc., who lend money to needy persons and institutions. Organized Sector The sector that is governed by some statutory or legal authority is known as organized sector. This sector consists of the institutions like Commercial Banks, Non Banking Financial Institutions, etc. They are further classified into two: 1. Capital Market Intermediaries 2. Money Market Intermediaries Capital Market Intermediaries Capital Market refers to the market for long term finance. The intermediaries provide long term finance to individuals and corporate customers. IDBI, SFCs, LIC, GIC, UTI, MFs, EXIM BANK, NABARD, NHB, NBFCs (Hire Purchasing, Leasing, Investment and Finance Companies) Government (PF, NSC) etc., are in the organized sector providing long term finance. Money Market Intermediaries Money Market refers to the market for short term finance. The intermediaries provide short term finance to individuals and corporate customers. RBI, Commercial Banks, Co-operative Banks, Post Office Savings Banks, Government (Treasury Bills) are in the organized sector providing short term finance. FINANCIAL MARKETS The group of individuals and corporate institutions dealing in financial transactions are termed as financial markets. Financial markets facilitates flow of investments. It provides monetary support for the growth of economy. Financial markets deals with financial securities and financial services. Where ever financial transactions exist financial markets exists. Issue of equity stock by a company, deposit of money in banks, purchase of bonds on secondary markets are few examples of financial transactions.Functions Financial Markets:1. Create and allocate credit and liquidity2. Intermediary for mobilization of savings3. Provide financial support conveniently4. Help in process of balanced economic growth5. Provide information and transactions at low cost6. Cater various credit requirements of business organizations.Classification of Financial Markets:1. Classification based on types of financial claim:· Debt Market: Transaction of fixed claims like debt instruments· Equity Markets: Transaction of residual claims like equity instruments 2. Classification based on seasoning of claims:· Primary Market: These markets deals with new securities. They are also known as new issue markets. These are the markets where securities are issued for the first time. In these markets securities are issued directly by the company. Primary markets are for mobilizing fresh capital in form of shares and debentures. · Secondary Markets: This market deals with existing securities. Existing securities are already issued and outstanding. It consists of stock markets which is self-regulated under purview of SEBI.3. Classification based on structure: · Unorganized Market: The sector that is not governed by any statutory or legal authority is known as unorganized sector. This sector consists of the individuals and institutions for whom there are no standardized rules and regulations governing their financial dealings. They are not under the supervision and control of RBI or any other regulatory body. Local money lenders, Pawn brokers, Traders, Landlords, Indigenous bankers, etc., who lend money are in the unorganized sector. · Organized Market: The sector that is governed by some statutory or legal authority is known as organized sector. This sector consists of the institutions for whom there are standardized rules and regulations governing their financial dealings. They are under the supervision and control of RBI and other statutory bodies. They are further classified into two: I. Capital Market : This market is for long term funds. It deals with securities and stocks with a maturity period of more than 1 year, long term claims. In this market capital is raised and made available for industrial purposes. Examples of capital market are: stock market, government markets and derivative markets. II. Money Market : This market where short term funds are borrowed and lend. This type of market deals with short term monetary assets with maturity less than 1 year. Liquid funds and highly liquid securities are traded here. Examples of this market are Treasury bill market, call money market, etc. Main participants are Banks, Financial Institutions and government. III. Foreign Exchange Market: Foreign exchange market is simply defined as a market in which one country’s currency is traded for another country’s currency. It is a market for the purchase and sale of foreign currencies. 4. Classification based on timing of delivery:· Cash/Spot Market: Buying and selling of commodities, stocks are sold for cash and delivered immediately after purchase or sale.· Forward/Future Market: In this market participants buy and sell stocks or commodities, contracts and the delivery of commodities or securities at a pre-determined time in future.5. Other financial markets:· Derivatives Markets: Derivatives are financial instruments for hedging risks. The individuals and firms who wish to avoid or reduce risk can deal with the others who are willing to accept the risk for a price. The important types of derivatives are forwards, futures, options, swaps, etc. FINANCIAL INSTRUMENTS Financial instruments refer to the documents that represent financial claim. A financial claim is claim to the repayment of a certain amount of money at the end of a specified period along with interest or dividend. Shares, Government Securities, Bonds, Mutual Funds, Units of UTI, Debentures, Bank Deposits, Provident Funds, LIC Policies, Company Deposits, Post Office Certificates, etc., are some of the examples of financial instruments. These instruments are classified into two types, viz., Primary securities and Secondary securities. Primary Securities – These are the financial instruments that are issued directly to the savers by the users of the funds. For example, shares or debentures issued by a joint stock company directly to the public and institutions are called as primary securities. Secondary Securities – These are the financial instruments that are issued to the savers by some intermediaries. For example, units issued by Unit Trust of India and other Mutual Fund Organizations are called as secondary securities FINANCIAL SERVICES Financial services refer to the activities of channelizing the flow of funds from the savers to the users. It involves the mobilization of savings of the persons and institutions who have surplus funds and allocating or lending them to the persons and institutions who are in need of such funds. The financial services are categorized into two groups, viz., Traditional services and Modern services 1. Traditional services refer to the services that the financial institutions are rendering from a very long time. They are further classified into two viz.,a) Fund based services and b) Non-fund or Fee based services. 2. Modern services refer to the services that the financial institutions are rendering in the recent years.