UNIT 1 THE ROLE OF FINANCIALMARKETS IN THE ECONOMY INTRODUCTION The financial system or the financial sector of any country
consists of:(a) (b) (c) specialized & non specialized financial institution organized & unorganized financial markets and Financial instruments & services which facilitate
transfer of funds.
It is an orderly mechanism and structure that is available in an economy to mobilize the monetary resources/capital from various surplus sectors of the economy and allocate and distribute the same to various needy sectors. The term financial system is a set of inter-related activities/services working together to achieve some predetermined purpose or goal. It includes different markets, the institutions, instruments, services and mechanisms which influence the generation of savings, investment capital formation and growth. Procedure & practices adopted in the markets, and financial inter relationships are also the parts of the system. These parts are not always mutually exclusive. For example, the financial institution operates in financial market and are, therefore a part of such market. The word system in the term financial system implies a set of complex and closely connected or inters mixed institution, agents practices, markets, transactions, claims, & liabilities in the economy. The financial system is concerned about money, credit, & finance the terms intimately related yet some what different from each other. Money refers to the current medium of exchange or means of payment. Credit or Loan is a sum of money to be returned normally with Interest it refers to a debt of economic unit. Finance is a monetary resources comprising debt & ownership fund of the state, company or person. FEATURES OF FINANCIAL SYSTEM 1. It provides an Ideal linkage between depositors savers and Investors Therefore it encourages savings and investment.
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2. Financial system facilitates expansion of financial markets over a period of time. 3. Financial system should promote deficient allocation of financial resources of socially desirable and economically productive purpose. 4. Financial system influence both quality and the pace of economic development. ROLE OF FINANCIAL SYSTEM The role of the financial system is to promote savings & investments in the economy. It has a vital role to play in the productive process and in the mobilization of savings and their distribution among the various productive activities. Savings are the excess of current expenditure over income. The domestic savings has been categorized into three sectors, household, government & private sectors. The savings from household sector dominates the domestic savings component. The savings will be in the form of currency, bank deposits, non bank deposits, life insurance funds, provident funds, pension funds, shares, debentures, bonds, units & trade debts. All of these currency & deposits are voluntary transactions & precautionary measures. The savings in the household sector are mobilized directly in the form of units, premium, provident fund, and pension fund. These are the contractual forms of savings. Financial actively deals with the production, distribution & consumption of goods and services. The financial system will provide inputs to productive activity. Financial sector provides inputs in the form of cash credit & assets in financial for production activities. The function of a financial system is to establish a bridge between the savers and investors. It helps in mobilization of savings to materialize investment ideas into realities. It helps to increase the output towards the existing production frontier. The growth of the banking habit helps to activate saving and undertake fresh saving. The financial system encourages investment activity by reducing the cost of finance risk. It helps to make investment decisions regarding projects by sponsoring, encouraging, export project appraisal, feasibility studies, monitoring & execution of the projects. NATURE OF FINANCIAL SYSTEM A financial system is a complex, well-integrated set of sub-systems of financial institutions, markets, instruments, and services which facilitate the transfer and allocation of funds, efficiently and effectively. There are four constituents of a financial system, viz. (i) financial institutions,
UNIT 1 THE ROLE OF FINANCIALMARKETS IN THE ECONOMY
(ii) (iii) (iv) financial markets, financial instruments, and financial services.
An overview of Financial System and Financial Markets in India
MINISTRY OF FINANCE
Financial Institutions
RBI
SEBI
IRDA
Insurance company
Mutual Fund
Venture Capital Fund
Capital Market
Commercial Banks
NBFC
Money Market
LIC & Other
GIC & Other
Primary Market Investment Banks Sectoral Banks State Level Financial Institution
Secondary Market
Stock Exchange
Government Security Market
UNIT 1 THE ROLE OF FINANCIALMARKETS IN THE ECONOMY
Development Banks
1. What do you mean by a Financial system? What are its different components?
UNIT 1 THE ROLE OF FINANCIALMARKETS IN THE ECONOMY
Ans: It is an orderly mechanism and structure that is available in an economy to mobilize the monetary resources/capital from various surplus sectors of the economy and allocate and distribute the same to various needy sectors. The term financial system is a set of inter-related activities/services working together to achieve some predetermined purpose or goal. It includes different markets, the institutions, instruments, services and mechanisms which influence the generation of savings, investment capital formation and growth. A financial system is a complex, well-integrated set of sub-systems of financial institutions, markets, instruments, and services which facilitate the transfer and allocation of funds, efficiently and effectively. There are four constituents of a financial system, viz. (i) Financial institutions, (ii) Financial markets, (iii) Financial instruments, and (iv) Financial services. 2. Define Financial institutions and also differentiate between different types of Financial institutions. Ans: Financial Institutions Financial institutions are business organisations that act as mobilisers and depositors of savings and as purveyors of credit or finance. They also provide various financial services to the community. These are those Institution which collects funds from the public and places them in financial assets, such as deposits, loans, and bonds, rather than tangible property. Financial institutions have been variously classified. Two important classifications are as follows: a) Banking institutions and Non-banking institutions The banking institutions have quite a few things in common with the non-banking ones, but their distinguishing character lien in the fact that unlike other institutions, (i)they participate in the economys payments mechanism, i.e., they participate in the economys payments mechanism, i.e., they provide transactions services, (ii) their deposit liabilities constitute a major part of the national money supply, and (iii) they can, as a whole, create deposits or credit which is money. Distinction between the two has been highlighted by Sayers by characterising the former as creators of credit, and the latter as were purveyors of credit. b) Intermediaries and Non-intermediaries Intermediaries intermediate between savers and investors; they lend money as well as mobilise savings; their liabilities are towards the ultimate savers, while their assets are from the investors or borrowers. Non-intermediary institutions do the loan business but their resources are not directly obtained from the savers.
UNIT 1 THE ROLE OF FINANCIALMARKETS IN THE ECONOMY
All banking institutions are intermediaries, many non-banking institutions also act as intermediaries and when they do so they are known as Non-Banking financial Inter-mediaries.
The various financial institutions generally act as an intermediary between the capital market and debt market. But the services provided by a particular institution depend on its type. The financial institutions are also responsible to transfer funds from investors to the companies. Typically, these are the key entities that control the flow of money in the economy. Financial Institutions in India are divided in two categories. The first type refers to the regulatory institutions and the second type refers to the intermediaries.
The regulators are assigned with the job of governing all the divisions of the Indian financial system. These regulatory institutions are responsible for maintaining the transparency and the national interest in the operations of the institutions under their supervision. The regulatory bodies of the financial institutions in India are as follows: Reserve Bank of India (RBI) Securities and Exchange Board of India (SEBI) Central Board of Direct Taxes (CBDT) Central Board of Excise & Customs Apart from the Regulatory bodies, there are the Intermediaries that
UNIT 1 THE ROLE OF FINANCIALMARKETS IN THE ECONOMY
include the banking and non-banking financial institutions. Some of the specialized financial institutions in India are as follows: Unit Trust of India (UTI) Securities Trading Corporation of India Ltd. (STCI) Industrial Development Bank of India (IDBI) Industrial Reconstruction Bank of India (IRBI), now (Industrial Investment Bank of India) Export - Import Bank of India (EXIM Bank) Small Industries Development Bank of India (SIDBI) National Bank for Agriculture and Rural Development (NABARD) Life Insurance Corporation of India (LIC) General Insurance Corporation of India (GIC) Shipping Credit and Investment Company of India Ltd. (SCICI) Housing and Urban Development Corporation Ltd. (HUDCO) National Housing Bank (NHB) The banking institutions of India play a major role in the economy of the country. The banking institutions are the providers of depository and transaction services. These activities are the major sources of creating money. The banking institutions are the major sources of providing loans and other credit facilities to the clients. Apart from the banking financial institutions, there are a number of specialized financial institutions in India that have been incorporated for a definite purpose. These institutions include the insurance companies, the housing finance companies, mutual funds, merchant banks, credit reporting and debt collection companies and many more. Apart from these, there are several other financial institutions that are existing in the country. These are the stock brokers and sub-brokers, portfolio managers, investment advisors, underwriters, foreign institutional investors and many more. FINANCIAL MARKET The US financial market or dollar market is the largest and the most versatile financial system in the world. It has the broadest range of funding options to offer and some of the most sophisticated and innovative financial institutions. The importance of this market is further enhanced by the dominant role played by the US dollar as the vehicle currency in international transactions, though over the years this has declined somewhat. At the same time, it is not a market that is readily accessible to borrowers from developing countries like India except perhaps those with the highest ratings and sovereign guarantees.
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Financial intermediaries have to perform the task of financial innovation to meet the ever-changing requirements of the economy and to help the investors cope with the increasingly volatile market. Because of this reason there is a necessity for the financial intermediaries to innovate unique financial instruments. 3. What are Financial markets? Distinguish between different types of Financial markets. Ans: Financial Markets Financial market are a mechanism enabling participants to deal in financial claims. The financial system is an important element of an economy. The financial resources are exchanged through the financial system. The financial market is the heart of the financial system. The financial market refers to a place or mechanism through which financial instruments are traded. According to S.K. Cooper and other Financial markets are the markets in which financial instruments are traded. Similarly, according to Dudley G. Luckett, Financial market is to be understood as any exchange of a variety of financial instruments. The financial market is said to the brain of entire economic system. The savings are channeled to investments through financial market. The financial instruments like stock, bond, insurance policy, government securities and debentures are traded in the financial market.
UNIT 1 THE ROLE OF FINANCIALMARKETS IN THE ECONOMY
Financial markets have been variously important classifications are: a) Primary market and secondary market; and b) Money market and capital market. The primary markets deal in the new financial claims or new securities, and, therefore, they are also known as new issue markets. Secondary markets deal in securities already issued or existing or outstanding. Primary markets mobilise savings and they supply fresh or additional capital to business units. Secondary markets do not contribute directly to the supply of additional capital, they do so indirectly by rendering securities issued on the primary markets liquid . Concept of Money Market In economics, market does not mean a particular place. Instead, the market is a process of buying and selling of goods by making contract through different mediums. Hence, money market also does not denote a particular place. The money market refers to the whole area where money is bought and sold. To be more precise, money market is simply a process of buying and selling of money. Unlike a stock exchange, the money market is not a particular place but is a system. The transactions may take place between different persons by telephone, fax without personal meeting. The short-term funds are transacted in the money market. In general the term of the loan is less than one year. Hence, the evidence of credit having maturity of less than one year is the instruments of money market. The main function of the money market is to make available working capital to the business and loan to the government. It also makes available loans for the speculation of goods and securities. The business firms use the money market to distribute wages and salaries, repair equipments, pay energy charge, taxes and so on. The government uses it to meet the deficit in public revenue. The finance companies use it to provide loans to the consumers. The banks use it to meet the temporary deficit in reserve. All these credit are only for up to one year. The meaning of money market becomes clear from the following definitions:classified. Two
UNIT 1 THE ROLE OF FINANCIALMARKETS IN THE ECONOMY
According Dudley G. Luckett -The money market is a market for short term (less than one year) loans. Its very name suggests that it is money that is being bought and sold. In the words of J.A. Cocharan, The money market is a market which trades in short term, highly liquid, negotiable debt instruments of one year or less in maturity. World Bank has defined the money market as, A market in which short term securities such as treasury bills, certificates of deposits and commercial bills are traded. In brief, the money market is a means of exchange of short term credit. It is quite different from the capital market which deals in long term credit. Concept of Capital Market The market dealing in long term finance is known as capital market. This market makes available funds for long-term investment. Hence, capital market is a market for long term credit. The meaning of capital market becomes clear from the following definitions:According to Dudley G. Luckett, A capital market is just what the name implies: a market for capital funds. Strictly speaking, the capital market encompasses any transactions involving long-term debt or equity obligations. In the words of S.K. Cooper and others , The framework for the borrowing and lending of funds for periods longer than a year is called the capital market. 4. Distinguish between Capital Market and Money Market Ans: Difference Between Money Market and Capital Market The money market and the capital market are interrelated. The main points of difference between these two markets are as follows:1. Maturity In general, these two markets are separated on the basis of the maturity of the credit instruments related to these markets. The maturity of the instruments of money market is one year or less than one year. On the other hand, the maturity of the instruments of capital market is more than one year.
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2. Risks The risks are less in money market. Because, there is less possibility of default of the credit of less than one year maturity. Likewise, the risk of interest rate is also low in the money market. On the other hand, the credit of the capital market is of long term nature. Due to this risks are more and are of varied nature in capital market. 3. Instruments The main instruments of money market are -treasury bills, commercial papers, certificate of deposit which are of short-term nature. On the other hand, the main instruments of the capital market are -debentures, equities or shares and government securities which are of long-term nature. 4. Institutions The different financial institutions related to short-term credit participate in the money market. But there is predominance of commercial banks. In fact, the commercial bank is an institution related to the money market. On the other hand, different kinds of financial intermediaries participate in the capital market. The main participants of the capital market are -development bank, finance company, provident fund, insurance company, Investment Company and so on. The service institutions are also involved in the capital market such as investment banking, commission brokers association, investment consultancy etc. In recent clays, the commercial banks also provide long-term loans to some extent. So they may also be included among the participants of the capital market. 5. Finance The money market deals in only short-term funds. It receives short term deposits and also provides the short-term credit. On the other hand, the capital market receives long-term deposits and also grants long term loan and equity capital to the business and the government. 6. Relation with the Central Bank The money market has close and direct relationship with the central bank. The central bank implements its monetary policy through this market. The central bank directly regulates the commercial banks in the money market. On the other hand, the central bank has influence over the capital market only indirectly through money market.
UNIT 1 THE ROLE OF FINANCIALMARKETS IN THE ECONOMY
Similarly, the institutions of the capital market are less regulated by the central bank. 5. What are Financial instruments? Ans: A real or virtual document representing a legal agreement involving some sort of monetary value. In today's financial marketplace, financial instruments can be classified generally as equity based, representing ownership of the asset, or debt based, representing a loan made by an investor to the owner of the asset. Foreign exchange instruments comprise a third, unique type of instrument. Different subcategories of each instrument type exist, such as preferred share equity and common share equity, for example. FINANCIAL SERVICES The financial system of a country has a great impact on the economy with financial services companies responsible for the robust economic growth. There has to be a direct link between the regulatory institutions and the intermediary institutions while determining the financial system of a country. Financial services provided by finance companies include insurance, housing financing, mutual funds, credit reporting, debt collection, stock broking, portfolio management, and investment advisory.
List of top 10 financial services companies in India
SBI Capital Markets Limited: This happens to be the oldest organizations in the sphere of capital markets in India. Established in 1986 in the form of an ancillary of SBI, they have ranked second in Asia's Project Advisory services. The company is a traiblazer in privatization and securitization. The subsidiaries of SBI Capital Markets are SBICAPs Ventures Ltd., SBICAP Trustee Co.Ltd. and many others. Bajaj Capital Limited: One of the major financial services companies in India, Bajaj Capital offers best investment advisory and financial planning services. The services are meted out to the institutional investors, NRIs, corporate houses, individual investors, high network clients as well. DSP Merrill Lynch Limited:
UNIT 1 THE ROLE OF FINANCIALMARKETS IN THE ECONOMY
A major player in the equity and debt market in India, DSP Merrill Lynch offers financial advises to varied corporations and institutions. With an array of wealth management and investor services, their services are customized in a manner that they meet every investor requirement. Birla Global Finance Limited: The subsidiary of Aditya Birla Nuvo Ltd., this company has operations in the corporate finance and capital market arena. An alliance with Sun Life Financial of Canada, they have given birth to Birla Sun Life Insurance Co Ltd., Birla Sun Life Distribution Co. and alike. Housing Development Finance Corporation: A best financial solution for home loans, NRI loans, HDFC is the one stop destination for personal finance. With overseas branches in Singapore, Kuwait, Qatar, Saudi Arabia and many others, HDFC has been going great guns every year. PNB Housing Finance Limited: This company offers premium solutions for relieving the borrower segment. The Home Loan Life Insurance Plan of this has come in conjunction with TATA AIG, with the lowest premium when compared to the peers. ICICI Group: Wide arena of financial products and services, ICICI Group has solutions like InstaBanking, Online Trading, Insta Insure, ICICI Bank imobile etc. Providing high class financial services in all segments of the society, ICICI Group deals with Mutual Fund, Private Equity, Securities, and Life Insurance etc. LIC Finance Limited: It is the biggest Housing Finance Company in India, providing finance to individuals for repair or construction or renovation of any old or new apartment or house. L & T Finance Limited: Established in 1994 by the Larsen and Turbo group, this has become a significant name in the financial sector. Funds for automobiles,
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Agricultural Instruments, secured loans; they have all types of loans for a long tenure.
Karvy Group: With Mutual Funds Services, Depository Services, Debt Market Services, Investment Banking and many others, Karvy Group has spanned across the domestic financial sector as well as abroad. 6. What are Financial services? Ans: Financial services are the economic services provided by the finance industry, which encompasses a broad range of organizations that manage money, including credit unions, banks, credit card companies, insurance companies, consumer finance companies, stock brokerages, investment funds and some government sponsored enterprises. Financial intermediaries provide key financial services such as merchant banking, leasing, hire purchase, credit -rating, etc. Financial services rendered by the financial intermediaries bridge the gap between the back of knowledge on the part of investors and increasing sophistication of financial instruments and markets. What are the functions of Financial systems in process of Economic Development? Ans: A financial system is a network of financial institutions, financial markets, financial instruments and financial services to facilitate the transfer of funds. The system consists of savers, intermediaries, instruments and the ultimate user of funds. The level of economic growth largely depends upon and is facilitated by the state of financial system prevailing in the economy. Efficient financial system and sustainable economic growth are corollary. The financial system mobilises the savings and channelizes them into the productive activity and thus influences the pace of economic development. Economic growth is hampered for want of effective financial system. Broadly speaking, financial system deals with three inter-related and interdependent variables, i.e., money, credit and finance. The first and foremost function which financial system perform is the channelization the savings of individuals and making it available for various borrowers which are the companies which take loan in order to increase the production of goods and services, which in turn increases the overall growth of the economy. It is with the help of financial system that one can make payment whenever and wherever he or she wants with the help of cheques, credit card and debit card. In the absence of financial system one has 7.
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to take cash wherever he or she goes which would have been impossible.
In order to play such a crucial role in economic development, a financial system performs following functions: Financial system works as an effective conduit for optimum allocation of financial resources in an economy. It helps in establishing a link between the savers and the investors. Financial system allows asset-liability transformation. Banks create claims (liabilities) against themselves when they accept deposits from customers but also create assets when they provide loans to clients. Economic resources (i.e., funds) are transferred from one party to another through financial system. The financial system ensures the efficient functioning of the payment mechanism in an economy. All transactions between the buyers and sellers of goods and services are effected smoothly because of financial system. Financial system helps in risk transformation by diversification, as in case of mutual funds. Financial system enhances liquidity of financial claims. Financial system helps price discovery of financial assets resulting from the interaction of buyers and sellers. For example, the prices of securities are determined by demand and supply forces in the capital market. Financial system helps reducing the cost of transactions. Hence the primary function of any financial system is to facilitate the allocation and deployment of economic
UNIT 1 THE ROLE OF FINANCIALMARKETS IN THE ECONOMY
resources, both spatially and temporally, in an uncertain environment. The financial system provides price information that helps coordinate decentralized decision-making in various sectors of the economy. The clear function of financial markets is to allow individuals and businesses to trade financial assets. An additional function of the capital market is to provide information that assists in decision-making. For example Interest rates and security prices are information that households use in making their consumption-saving decisions.
FLOW OF FUNDS IN THE FINANCIAL MARKETS
The flow of funds function concerns the flow of funds from surplus units to deficit units in the financial system. Surplus units are entities with savings (income > expenditures) whereas deficit units are the exact opposite (expenditures > income). The financial system allows for an efficient allocation of funds by transferring available funds from surplus units to deficit units. Deficit units can then use these funds to meet their needs, in the expectation that they return these funds at a later date. It is important to note that being a surplus unit does not mean you cant be a deficit unit. For example, a person deposits money in his bank account, but has a mortgage for his house. The financial system aims to match suppliers with deficit units that pose a level of risk that is acceptable to the suppliers. Saving and investments are flow concepts as opposed to stock concepts. Investment is the process of capital formation. The existing stock of capital depreciates overtime as it is used in producing consumer goods or other investment goods, so the net investment is the net addition to the stock of capital occurring over a period of time. These additions to the stock of capital are real investment.
What are flow-of-funds accounts? The flow-of-fund accounts include all the sources and uses of funds for the various sectors of the economy, and by summation, for all sectors. Although aggregate saving and investment must be equal, ex post, for the entire economy, it is unlikely that saving will equal investment for a particular sector during a given period. Saving may exceed investment; the surplus on current account will have been used for purposes other than financing current expenditures. For example, the surplus funds may have been used to buy securities or to take loans. If a sector has investment greater than saving,
UNIT 1 THE ROLE OF FINANCIALMARKETS IN THE ECONOMY sources other than its own saving will have provided the funds necessary to finance these expenditures. Thus, saving is but one source of funds; investment is but one use of funds.
Data for Flow-of-Funds Accounts Flow of funds data for an economy are derived for a specific period of time by (1) dividing the economy into sectors, (2) preparing a source and use of funds statement for each sector, (3) summing the sources and uses for all sectors, and (4) placing the sector accounts side by side to form a table or matrix. A matrix may consist of only a few sectors. For example, the entire economy can be divided into households, business firms, governments and financial institutions. In a more complex matrix, these sectors may be subdivided with additional categories established for different types of business firms, government units, financial institutions, and so on. And if foreign transactions are to be considered, it is necessary to include a sector for the rest of the world. The larger the number of sectors, the more likely it is that each sector will be composed of relatively homogeneous units. Ideally, each group's market behaviours will be similarly influenced by the same set of economic variables. However, if the economy is divided into too many sectors, the model becomes cumbersome, so too much detail may obscure more important relationships between them. The optimum number of groups depends ultimately on the purpose of the analysis and the degree of disaggregation necessary, on the availability of data, and on the time and effort required to collect and assemble the date.
The second step in construction of flow of funds accounts is to prepare a source and use statement for each sector. This is done by examining the balances sheets of the various sectors at the beginning and end of a quarter or a year. Net changes are noted in the stock of assets, liabilities, and net worth that occurred during the period. Certain assets might have increased in value, others declines: some liabilities may be greater and some smaller than at the beginning of the period. The convention is to treat increases in assets as a use of funds and increases in liabilities or net worth as a source of funds. On the users side, the sum of the changes in real and financial assets must be equal to, on the sources side to change in liabilities and change in net worth. A simple source and use statement for a given sector shows intersectoral flows on a new basis. That is, it does not record intersector transactions; for example, a loan by one business firm to another would be excluded. Also, only net increases in assets are treated as uses of funds. Debt repayment or dissaving, which are in
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fact uses of funds, are treated as negative sources of funds. In the same way, disinvestment in real assets or the sale of securities, which are in fact sources of funds, are treated as negative uses. This characteristic of the accounts facilities handling the data uniformly, but unfortunately it may also obscure some changes both within sectors and among different sectors. For a given sector, and by summing all
sectors, for the economy as a while, the following equality is obtained: net worth + liabilities = real assets + financial liabilities. ( denotes 'change') Or, saving + borrowing = investment + lending It follows that if, in a particular sector, saving > investment, then lending > borrowing. This sector is a surplus sector and a net lender to other sectors. If investment > saving, then borrowing > lending. In this case the sector is a deficit sector and a net borrower from other sectors. In principle, an account is easily established for each of the several sectors that make up the economic system. Sources and uses of funds are identified as in the case of our hypothetical sector. If we place these statements side by side, we form a matrix to describe an interconnected system of flow of funds for, say, a year. ------------------------------------------------------------------------------------------------
