Unit 1

INTRODUCTION TO FINANCIAL SYSTEM

Financial system
The economic development of a nation is reflected by the progress of the various economic
units, broadly classified into corporate sector, government sector , government and
household sector. There are areas or people with surplus funds and there are those with a
deficit. A financial system or financial sector functions as an intermediary and facilitates
the flow of funds from the areas of surplus to the areas of deficit. A financial system is
composition of various institutions, markets, regulation and laws, practices, money manager,
analysis, transactions and claims and liabilities.
The term ‘financial services means mobilizing and allocating savings. Thus, it includes all
activities involved in the transformation of savings into investment.
Financial system comprises of set of subsystems of financial markets, financial institutions,
financial instruments and services which helps in the formation of capital. It provides a
mechanism by which saving s are converted into investment.

Functions of financial systems

1. Pooling of funds
In a financial system, the savings of people are transferred from household to
business organizations. With these production increases and better goods are
manufactures, which increases the standard of living of people.
2. Capital formation
Business require finance these are made available though banks , household and
different financial institutions. They mobilize savings which leads to capital formation.
3. Facilitates payment
In financial system offers convenient modes of payment for goods and services. New
methods of payments like credit cards, debit cards, cheques, etc. facilitates quick and
easy payments.
4. Provides liquidity
In financial system, liquidity means the ability of convert intro cash. The financial
market provides the investors the opportunity to liquidate their investment, which are
in instruments like shares, debentures, bonds, etc. price is determined on the daily
basis according to the operations of he market force of deemed and supply.
5. Short- and long-term needs
The financial market considers the various needs of different individuals and
organizations. These facilities optimum use of finances for productive purpose.
6. Risk function
The financial markets provide protection against life, health, and income risks. Risk
management is an essential component of a growing economy.
7. Better decisions
Financial markets provide information about the market and various financial assets.
This helps the investors to compare different investment options and choose the best
one. It helps in decision making in choosing portfolio allocations of their wealth.

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Components of financial systems
Financial components
➢ Financial instruments or financial asset
➢ Financial market
➢ Financial intermediaries
➢ Financial services

1. Financial asset
A financial asset is nothing but the financial instruments which are used to raise fund
for the business. Examples of financial assets are share, debenture, bonds, mutual
funds, etc.
Financial asset vs. physical assets
Physical assets are the real assets which are in the day to activity by the business as
well as household purposes. For ex. Land , building, car etc. these assets are physical
assets. On the other hand, financial assets are the securities by issuing which company
can raise fund form the public.

financial asset

non
marketable
marketable
assets
securities

govt bearer providend

shares bonds bank deposits lic scheme
securities debenture fund

2. Financial markets
Financial markets are the center that facilitates buying and selling of financial instruments
claims or services. It caters the credit needs of the individuals, firms and institutions. It
deals with the financial assets of different types such as currency deposits, cheques, bills,
bonds etc. it is defined as a transmission mechanism, between investors and the borrowers
thorough which transfer of funds is facilitated. It consists of individual investors , financial
institutions and other intermediators who are linked by a formal trading rules and
communication network.
3. Financial intermediators
A financial intermediary is an institution which connects the deficit and the surplus. The
best e.g. of an intermediary can be a bank which transforms the bank deposits to bank loans.
The role of financial intermediary is to channel funds from people who have extra inflow of
money i.e. the savers to those who do not have enough money to fulfill the needs or to catty
out the basic activities i.e. the borrowers.
It can also be classified as follows
✓ Capital market intermediaries
✓ Money market intermediaries

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Capital market intermediaries
These intermediaries mainly provide long term funds to individuals and corporate customers.
They consist of term lending institutions like financial corporations and investing institutions
like LIC.
Money market intermediaries
Money market intermediaries supply only short-term funds to individuals and corporate
customers. They consist of commercial banks, cooperative banks, etc.
4. Financial services
Financial services refer to services provided by the finance industry. The finance industry
consists of a board range of organization that deal with the management of money. These
organizations include banks, credit and companies, insurance companies, consumers finance
companies, stock brokers, investment funds and some govt sponsored enterprises. On the
other hand, financial services may be defined as the products and services offered by
financial institutions for the facilitation of various financial transactions and other related
activities.

Financial market
There is no specific place or location to indicate a financial market. When and where a
financial transaction takes place, it is deemed to have taken place in the financial market.
Hence financial markets are pervasive in nature since financial transactions are themselves
very pervasive thought out the economic system. For instance, issue of equity shares,
granting of loans by term lending institution, deposit of money into bank, purchase of
debenture, sales of shares and so on.
Classification of financial market
There are basically 2 types of financial market in India
❖ Organized market
❖ Unorganized market

Organized market
Organized market are those markets which has certain standardized rules and regulations
for controlling and governing their financial dealing. There are also financial institutions,
whose activities are strictly controlled by the RBI and other regulatory body.
These organized markets are divided into 2 categories
1. Capital market
The capital market is a market for financial assets which have a maturity period of more
than one year. Generally, it deals with long term security which has a maturity period of more
than 1 year. On the other hand, capital market is a market where long-term securities are
traded. Capital market may be further divided in to 3 parts
i. Industrial market
It is ,market for individual securities namely equity shares or ordinary shares, preference
share, debenture or bond etc. are traded. On the other hand, it is a market where industrial

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sector raised their capital or debt by issuing appropriate instrument. It can be divided in to
2 types
a. Primary market
Primary market is also called new issued market where securities are issued to public for
first time which is known as IPO (initial public offer). On the other hand, primary market
deals with those securities which are issued to the public for the first time.
There are 3 ways by which a company raises capital in a primary market
❖ Public issues
The most common method of raising capital by new companies though sale of securities
to the public is called public issues. When a company issued shares or any other
security to the public first time is called public issue.
❖ Right issues
When a company wants to raise additional capital from the existing shareholders, then
the company will issue new securities to the existing share holder it is called right
issue. In case of rights issue the existing share, holders have the rights to subscribe
shares from the company on proportionate basis.
❖ Private placement
It means a company can sale their securities in privately to small group of institutional
investors instead of issuing the security to public or existing shareholders. So, when
company issue securities privately to some selected group of investors that is called
private placements.
b. Secondary market
Secondary market is market for existing securities which are already issued in primary
market. On the other hand, it is a market for secondary sale of securities or securities
which have already passed though the new issuing market are traded in this market generally
such securities are traded in the stock exchange and it provides a continue and regular
market for buying and selling of securities.
2. Govt security market
It is a market where government securities are traded in India there are many kinds
of Govt. security are traded such as short term and long-term securities. Only long-
term securities are traded in capital market and short-term securities are traded in
the money market.
3. Long term loan market
Development bank and commercial bank plays a significant role in this market by
supplying long term loans to corporate customers. Long term loan market may be
further classified in to 3 types
❖ Term loan market
In India many industrial financing institutions have been ready to provide long term
and medium-term loan to corporate consumers. Directly as well as indirectly, these
development bank dominate the industrial finance in India.

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 ❖ Mortgage market
It is referring to these centers who supply mortgage loan mainly to individual
customer. A mortgage loan is a loan against the securities of in moveable property to
secure a loan is called mortgage.
❖ Financial guarantees market
The guarantees market is center is a center where finance is provided against the
grantee circle. Guarantee is a contract to discharge the liabilities to third party in
case of the defaults. Guarantee acts as a security from the creditors point of view. In
case the borrower fails to repay the loan, the liabilities take the responsibilities as a
guaranty basis.
Unorganized market
In the case of Indian banking system, indigenous bankers are included in the unorganized
sector. Indigenous bankers include those individuals and banks who accept deposits or
depend on credit to run their business. They deal with short term credit instruments for the
purpose of providing financial help for goods and services.

E-commerce
E-commerce or electronic commerce, EC is the buying and selling of goods and services, or
the transmitting of funds or data, over an electronic network, primarily the internet. E-
commerce allows people to create completely new business models. Electronic commerce or e-
commerce refers to the buying and selling of products or services over electronic systems
such as the internet and other computer networks.
Meaning
e-commerce refers to commercial transaction conducted online. This means that whenever
you buy and selling something using the internet, you are involved in e-commerce. E-
commerce is the buying and selling the goods and services thought internet or digital
communication.
Electronic commerce is a general term used applied for use of computers and
telecommunication technologies to supports trading in goods and services. Itis defined as any
form of business transaction in which the parties interact electronically rather then by
physical exchanges or directly physical contact.
Features of E-commerce
1. Widely used
the traditional business market is a physical place access to treatment by means of
document circulation. For ex: clothes and shoes are usually directed to encourage
customers to go somewhere to buy. E-commerce is ubiquitous meaning that it can be
everywhere.
2. Global reach
e-commerce allows business transactions on the cross country bound can be more
convenient and more effective as compared with the traditional commerce. On the e-
commerce business potential market scale is roughly equivalent to the network the
size of the world’s population.

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 3. Universal standards
e-commerce technologies are an unusual feature, is the technical standard of the
internet, so to carry out the technical standard of e-commerce is shared by all
countries around the world standard . standard can greatly affect the market entry
cost and considering the cost of the goods on the market.
4. Richness
Advertising and branding are an important part of commerce. E-commerce can deliver
video, audio, animation, signs and etc. however it’s about a s rich as television
technology.
5. Interactivity
Twentieth century electronic commerce business technology is called interactivity so
they allow for two-way communication between business and consumers.
6. Personalization
e-commerce technology allows for personalization. Business can be adjusted for a
name, a person’s interest and past purchases message objects and marketing massage
to a specific individual. The technology also allows for custom . merchants can change
the product or service based on user preferences or previous behavior.

Types of E-commerce
There are 6 types of e-commerce. They are B2B,B2C,C2C,C2B,B2A,C2A all these 6 types of
e-commerce that are used today are classified based on the nature of the transaction.
1. B2B (business to business)
B2B ecommerce can be simply defined as the commerce between companies. In
business to business type of electronic commerce system, companies do business with
each other.
2. B2C (business to consumer)
B2C model works as its name suggest. In thus model, the company sells their products,
goods or sell directly to the consumer online. Here the customer can view products on
the website that they want to buy can order it. After receiving the order details the
company will process the order and then send the product directly to the consumer.
For ex: AMAZON, FLIPKART, etc.
3. C2C (consumer to consumer)
Here a consumer sells products, goods or services to other consumers using the
internet or the web technologies. The C2C business models helps us to sell our assets
or properties like car, house, bike, electronics, etc. via online to other consumers.
For ex; OLX, quicker, etc.
4. C2B (consumer to business)
A consumer to the business model is type of commerce where a consumer or end user
provides a product or services to an organization. It is the reverse model of the B2C
or business to consumer model, where business produce products and services for the
consumers consumption. In this business model, individual customers offer to sell
products or services to the companies who are prepared to purchase them.

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 5. B2A (business to administration)
B2A or business to administration also referred as the business to government (B2G)
Commerce, it is a derived of B2B ecommerce model. In this model, the business and
government agencies use central websites to exchange information and do business
with each other more efficiently then they usually can off the web.
6. C2A (consumer to administration)
Consumer to administration or consumer to government e-commerce model helps
consumers to request information or post various feedbacks regarding public sectors
directly to the government authorities or administration. For say , making electricity
bill payments though the website government, making payment of taxes, payment of
health insurance is C2A type of business model.
Advantages of E-commerce
1. More clients
There is no local store or company with sufficient offices in different cities that
compares with e-commerce’s reach. The possibility of selling and buying from any part
of the world expenses the target public and allows the company to gain more clients.
2. No schedule or time limit
e-commerce does not run on schedules that means particular time, where as it is
nearly impossible to find a traditional store that is open 24/7. Website are open all
day long clients can buy whatever they want whenever they want it.
3. Less cost
Not need in a physical store reduces the costs of running a traditional business. In
addition , when e-commerce brings suppliers together with consumers there are not
even production costs.
4. Bigger profit margin
Cost reduction and market extension mean that , even with lower prices, a bigger
profit margin can be obtained than with a traditional store. More products are sold
and more money is made.
5. Scalability
This means that you can sell or either one or to a thousand people at the same time. In
a physical store there is always a limit to the number of clients that you can assist at
the same time. On the other hand, with e-commerce, the only limit is your ability to
attracts clients.

Meaning of DFI (DOMESTIC FINANCIAL INSTITUTION)

A DFI is defined as “ an institution promoted or assisted by government mainly to provide
development finance to one or more sectors or sub sectors of the economy. “the institution
distinguishes itself by a judicious balance between commercial norms of operation, as
adopted by any privier financial institution, and development obligations. DFIs adopted the
“project approach” – emphasizing the viability of the project to be financed – against the
“collateral approach”.

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Role of domestic financial institutions (DFI)
Financial institutions provide means and mechanism of transferring resources from those
who have as excess of income over expenditure to those who can make productive use of the
same. These institutions help economic development in the following ways.
1. Providing funds
These institutions help large number of persons for taking up some industrial activity.
The addition of new industrial units and increase the activities of existing units will
certainly help in accelerating the pace of economic development. Financial institutions
have large investible funds which are used for productive purpose.
2. Infrastructural facilities
Financial institutions prepare their investment policies by keeping national priorities in
mind. The institutions invest in those areas which can be help in increasing the
development of the country.
3. Promotional activities
Financial institutions have the expertise and man power resources for undertaking the
exercise of starting a new unit. So, these institutions take up this work on behalf of
entrepreneurs. The promotional role of financial institutions is helpful in increasing
the development of a country.
4. Development of backward areas
In order to help the development of backward areas financial institutions provide
special assistance to entrepreneurs for setting up new units in these areas.
IDBI,IFCI,ICICI give priority in giving assistance to unit’s setup in backward areas
even charge lower interest rates on lending.
5. Planned development
Different institutions earmark their spheres of activities so that every business
activity is helped. Some institutions like SIDBI, SFCI’s especially help small scale
sector while IFCI and SIDC’s finance large scale sector or extend loans above a
certain limit. Some institution s helps different segments like foreign trade, tourism,
etc.
6. Accelerating industrialization
The setting up of more industrial units will generate direct and indirect employment
make available goods and services in the country and help in increasing the standard of
living. Financial institutions provide requisite financial, managerial, technical help for
setting up new units.

Universal banking
Universal banking is combination of commercial banks, investment banking, development
banking, insurance and many other financial activities. It is a place where all financial
products are available under one roof. So, a universal bank which offers commercial bank
functions plus other functions such as merchant banking, mutual funds, factoring, credit
cards, housing finance, auto loans, retail loans, etc.
Universal banking includes not only services related to savings and loans but also investments.
Universal banking is done by very large banks. These banks provide a lot od finance to many
companies. So, they take part in the corporate governance of these companies. These banks

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have a large network of branches all over the country and all over the world. They provide
many different financial services to their clients.
Advantages of universal banking
1. Ecommerce of scale
Universal banking result in greater economics efficiency in the form of low cost,
higher output and better products. In India, RBI is in favor of universal banking
because it results in economics of scale.
2. Profitable diversions
The banks can utilize its existing skill in single type of financial services in offering
other kind s by diversifying the activities. Therefore, it involves lower cost in
performing all types of financial functions by one unit instead of other institution.
3. Resources utilization
A bank possesses all types of information about the existing customers which can be
utilized to perform other financial activities with the same customer.
4. Easy marketing
A bank with established brand name can easily use its existing branches and staff to
sell the other financial products like insurance policies, mutual fund plans without
spending much effort on marketing.
5. Under one roof
Universal banking offers all financial products and services under one roof. It saves
transaction cost and time. It also increases the speed of work. Hence it is beneficial
to bank as well as customer.
6. One -stop shopping
One stop shopping is beneficial for the bank and its customers as it saves lot of
transactions costs by increasing the speed of economics activities.

Disadvantages of universal banking

1. No expertise in long term lending
These are different types of long-term loans like project finance and infrastructure
finance, having long gestation projects can not properly handle by the single bank.
2. Non-performing assets problem
One of the most serious problems faced by universal banking is non-performing assets.
3. Risk failure
The larger the banks, the greater the effects of their failure on the system. The
failure of a larger institutions could have serious for the entire banking system. If one
universal bank were to collapse, it could lead to a systemic financial crisis.
4. Different rules and regulations
In offers all financial product and services under one roof. However, all these
products and services have to follow different rules and regulation of RBI, SEBI,
IRDA. This create many problems because same bank has to follow different rules and
regulation for different products.

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 5. Conflict of interest
Combining commercial and investment banking can result in conflict of interest. Some
banks give more importance to one types of banking and less importance to another
one.

Central bank / reserve bank of India (RBI)

The reserve bank of India id India’s central bank. It is apex monetary institution which
supervise, regulates controls and develops the monetary and financial system of the country.
The reserve bank was established on April 1, 1935 under the reserve bank of India act, 1934.
Initially , it was constituted ad private share-holders bank with a fully paid-up capital of ₹ 5
crore. But it was nationalized on January 1 , 1949.
RBI(reserve bank of India)
The central bank plays an important role in the monetary and banking structure of nation. It
supervises controls and regulates the activities of the banking sector. It has been assigned
to handle and control the currency and credit of a country. In older days the central bank
was empowered to issue the currency notes and bankers to the union governments.

Objectives of RBI
It plays a more positive and dynamic role in the development of a country. The financial
muscle of a nation depends upon the soundness of the policies of the central banking. The
objectives of the central banking system are presented:
➢ The central bank should work for the national interest of the country.
➢ The central bank must aim for the stabilization of the mixed economy.
➢ It aims at the stabilization of the price level at average prices.
➢ Stabilization of the exchange rate is also essential.
➢ It should aim for the promotion of economic activities.
Functions of RBI
The RBI functions are based on the mixed economy. The RBI should maintain a close and
continuous relationship with the union government while implementing the policies.
The main functions of the RBI are presented below:
• Welfare of the public
• To maintain the financial stability of the country
• To execute the financial transaction safely and effectively
• To develop the financial infrastructure of the country
• To allocate the funds effectively without any partiality.
• To regulate the overall credit volume for price stability.
Various authorities of RBI
1. Currency issuing authority
The RBI has the sole authority to issue the currency notes and coins . it is the
fundamental right of the RBI. The coins and one-rupee notes are issued by the
government of India and they are circulated thought RBI. The notes issued by the RBI
will have legal identity every were in India.

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 2. Monitoring authority
The RBI has the full authority to control all the aspects of the banking system in
India. The RBI is known as the banker’s bank. The banking system in India works
according to the guidelines issued by the RBI. The RBI is the premier banking
institute among the commercial banks. All the commercial banks , foreign banks and
cooperative banks in India should obey the rules and regulation which are issued by
the RBI from time to time.
3. Bankers to the union government
Generally, in nay country al over the world the central bank dominates the banking
sector. It advises the =government on monetary policies. The RBI is the bankers to
the union government and also to the state governments in the country. It provides
the wide rage of banking services to the government. It also transfers the funds,
collects the receipts and makes the payment on behalf of the government. It also
manages the public debt.
4. Foreign exchange regulations
The RBIS another major function is to control the foreign exchange reserves position
from time to time. It maintains the stability of the external value of the rupee
through its domestic policies and forex market. It administrates the FERA act ,1973.
It is replacing by the FEMA which should be consistent with full capital account
convertibility with policies of the central government.
5. Promoting authority
The RBIs function is to look after the welfare of the financial system. It renders the
promotion services to strengthen the country’s banking and financial structure. It
helps in mobilization the savings and diverting them forwards the productive channel.
Thus, the economic development can be achieved. After the nationalization of the
commercial banks, the RBI has taken a number of series of actions in various sectors
such as industrial sector, agriculture sector, lead bank scheme and corporate sectors.
Monetary policies of RBI
✓ Bank rate
Bank rate also referred to as the discount rate. It is the rate of interest which a
central bank charges on the loan and advances to a commercial bank.
✓ Repo rate
When we need money , we take loans from banks and banks charges certain interest
rate on these loans. This is called as cost of credit. Similarly, when banks need money
they approach RBI. The rate at which banks borrow money from the RBI by selling
their surplus government securities to the central bank is known as “repo rate”
✓ Reverse repo rate
Reverse repo rates the rate of interest offered by the RBI, when banks deposits
their surplus funds with the RBI for short periods. When banks have surplus funds
but have no lending or investment options, they deposit such funds with RBI. Banks
earn interest on such funds. Reverse repo rate is the rate at which the RBI borrows
money from commercial banks.

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 ✓ CRR
Under CRR a certain percentage of the total bank deposits has to be kept in the
current account with RBI which means bank do not have access to that much amount
for economic activity or commercial activity.
✓ SLR
Every bank is required to maintain at the close of business every day, a minimum
proportion of their net demand and time liabilities as liquid assets in the form of cash
, gold and other securities. the ratio of liquid asset to demand and time liabilities is
known as statutory liquidity ratio.

Financial intermediaries
A financial intermediary is an entity that facilities a financial transaction between two
parties. Such an intermediary or a middle man could be a firm or an institution. Some
examples of financial intermediaries are banks, insurance companies, pension funds,
investment banks and more.
A financial intermediary is a firm or an institution that acts an intermediary between a
provider of service and the consumer. It is the institution or individual that is in between
two parties in a financial context.
Financial intermediation
Financial intermediaries work in the savings/investment cycle of an economy by serving as
middle man to finance between the borrowers and the tenders. In the financial system,
intermediaries like banks and insurance companies have a huge role to play given that it has
been estimated that a major proportion od every dollar financed externally has been done by
the banks . financial intermediaries are an important source of external funding for
corporates unlike the capital markets where investors contract directly with the corporates
creating marketable securities.
Examples of financial intermediaries
1. Banks
The intermediaries are licensed to accept deposits, give loans and offer many other
financial services to the public. They play a major role in the economic stability of a
country and thus face heavy regulations.
2. Mutual funds
Mutual funds help pool savings of individual investors into financial markets. A fund
manager oversees a mutual fund and allocates the funds to different investment
products.
3. Financial advisors
Such intermediaries may or may not offer a financial product, but advises investors to
helps them achieve their financial objectives.
4. Credit union
It is also a type of bank, but works to serve its members and not public. They may or
may not operate for profit purpose. Other financial intermediaries are pension funds,
insurance companies, investment banks and more.

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Functions of intermediaries
❖ the biggest function of these intermediaries is to convert savings into investment.\
❖ Intermediaries like commercial banks provide storage facilities for cash and other
liquid assets, like precious metals.
❖ Giving short- and long-term loans is primary function of the financial intermediaries.
These intermediaries accept deposits form the entities with surplus cash and then
loan then to entities in need of funds. Intermediaries give the loan at interest, part of
which is given to the depositors, while the balance is retained as profit.
❖ Another major function of these intermediaries is to assist clients to grow their
money via investment intermediaries like mutual funds and investment banks use their
experience to offer investment products to help their clients maximize and reduce
risks.
Roles of financial intermediaries
✓ Mobilizes savings into investment
✓ Provides storage facilities such as locker for cash and precious metals
✓ Provide funds on the basis of short term or long-term needs.
✓ Assist investors to grow their money by investing and maximizing their returns.
✓ Provide interest on investment made.
Advantages of financial intermediaries
 They help in lowering the risk of an individual with surplus cash by spreading the risk
via lending to services people.
 They help in saving time and cost. Since these intermediaries deals with a large
number of customers, they enjoy economics of scale.
 Since they offer a large number of services, it helps them customize services for
their client. For instance, banks can customize the loans for small and long-term
borrowers or as per their specific needs. Similarly, insurance companies customize
plans for all age groups.
 They accumulate and process information, thus lowering the problem of asymmetric
information.

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