UNIT-1: Financial System: Institutions, Markets primary, secondary, money and Capital markets, Instruments of Money Market, Functions

s and their Economic Significance

Financial System of any country consists of financial markets, financial intermediation and financial instruments or financial products. The term "finance" in our simple understanding it is perceived as equivalent to 'Money'. We read about Money and banking in Economics, about Monetary Theory and Practice and about "Public Finance" . But finance exactly is not money; it is the source of providing funds for a particular activity. Thus public finance does not mean the money with the Government, but it refers to sources of raising revenue for the activities and functions of a Government. Here some of the definitions of the word 'finance both as a source and as an activity i.e. as a noun and a verb. The American Heritage Dictionary of the English Language, Fourth Edition defines the term as under 1. "The science of the management of money and other assets."; 2. "The management of money, banking, investments, and credit. "; 3. "finances monetary resources; funds, especially those of a government or corporate body" 4. "The supplying of funds or capital." 5. "To provide or raise the funds or capital for": financed a new car 6. "To supply funds to": financing a daughter through law school. 7. "To furnish credit to". 8. "the commercial activity of providing funds and capital" 9. "the branch of economics that studies the management of money and other assets" 10. "the management of money and credit and banking and investments" 11. "obtain or provide money for;" " Can we finance the addition to our home?" 12. "sell or provide on credit "

INDIAN FINANCIAL SYSTEM The economic development of a nation is reflected by the progress of the various economic units, broadly classified into corporate sector, government and household sector. While performing their activities these units will be placed in a surplus/deficit/balanced budgetary situations 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 a composition of various institutions, markets, regulations and laws, practices, money manager, analysts, transactions and claims and liabilities.

Financial System The word "system", in the term "financial system", implies a set of complex and closely connected or interlined institutions, agents, practices, markets, transactions, claims, and liabilities in the economy. The financial system is concerned about money, credit and finance-the three terms are intimately related yet are somewhat different from each other. Indian financial system consists of financial market, financial instruments and financial intermediation.

FINANCIAL MARKETS A Financial Market can be defined as the market in which financial assets are created or transferred. As against a real transaction that involves exchange of money for real goods or services, a financial transaction involves creation or transfer of a financial asset. Financial Assets or Financial Instruments represents a claim to the payment of a sum of money sometime in the future and /or periodic payment in the form of interest or dividend.

Money Market The money market ifs a wholesale debt market for low-risk, highly-liquid, short-term instrument. Funds are available in this market for periods ranging from a single day up to a year. This market is dominated mostly by government, banks and financial institutions. Capital Market The capital market is designed to finance the long-term investments. The transactions taking place in this market will be for periods over a year.

Forex Market The Forex market deals with the multicurrency requirements, which are met by the exchange of currencies. Depending on the exchange rate that is applicable, the transfer of funds takes place in this market. This is one of the most developed and integrated market across the globe. Credit Market Credit market is a place where banks, FIs and NBFCs survey short, medium and long-term loans to corporate and individuals.

Functions performed by a financial system

Saving function

Public saving find their way into the hands of those in production through the financial system. Financial claims are issued in the money and capital markets which promise future income flows. The funds with the producers result in production of goods and services thereby increasing society living standards. Liquidity function

The financial markets provide the investor with the opportunity to liquidate investments like stocks bonds debentures whenever they need the fund. Payment function

The financial system offers a very convenient mode for payment of goods and services. Cheque system, credit card system etc are the easiest methods of payments. The cost and time of transactions are drastically reduced. Risk function

The financial markets provide protection against life, health and income risks. These are accomplished through the sale of life and health insurance and property insurance policies. The financial markets provide immense opportunities for the investor to hedge himself against or reduce the possible risks involved in various investments. Policy function

The government intervenes in the financial system to influence macroeconomic variables like interest rates or inflation so if country needs more money government would cut rate of interest through various financial instruments and if inflation is high and too much money is there in the system then government would increase rate of interest.

FINANCIAL INTERMEDIARIES
Financial institution, such as a commercial bank or savings and loan association, that accepts deposits from the public and makes loans to those needing credit. By acting as a middleman between cash surplus units in the economy (savers) and deficit spending units (borrowers), a financial intermediary makes it possible for borrowers to tap into the vast pool of wealth in federally insured deposits-accounting for more than half the financial assets held by all financial service companies-in banks and other depository financial institutions. The movement of capital from surplus units through financial institutions to deficit units seeking bank credit is an indirect form of financing known as intermediation-consumers are net suppliers of funds, whereas business and government are net borrowers. A bank gives its depositors a claim against itself, meaning that the depositor has recourse against the bank (and, if the bank fails, the deposit insurance fund protecting insured deposits), but has no claim against the borrower who takes out a bank loan

CLASSIFICATION OF FINANCIAL MARKETS IN INDIA According to the period of maturity of the financial assets with which the markets are dealing, the markets can be classified as 1. Money Market. 2. Capital Market. These markets are again classified as primary markets and secondary markets. Money market deals with instruments having a period of maturity of one year or less like treasury bills, bills of exchange etc. Capital market deals with all instruments having a period of maturity of above one year like corporate debentures, government bonds, equity and preference shares etc. Money Market Money market deals in short-term debt, and channel the savings into short-term productive investments like working capital, call money, treasury bills etc. In India, money market is classified into the organized segment and unorganized segment. The organized segment is characterized by fairly rigid and complex rules and is dominated by commercial banks and major financial institutions like UTI. This segment is subjected to tight control by the Reserve Bank of India. The Unorganized segment is characterized by informal procedures; flexible terms and attractive rates of interest both depositors and borrowers. The unorganized sector is dominated by money lenders. The Discount and Finance House of India (DFHI) is a finance house established as a company under the Companies Act, 1956. I t is providing liquidity to money market instruments by creating a secondary market and offering buying / selling quotes for various instruments. RBI actually operates in the money market through the DFHI

 The position of money market in the Indian system has become important with recent liberalization of monetary policies, such as deregulation of lending rates, permitting mutual funds and banks subsidiaries to enter into money market operations. Money market ensures efficient functioning of the financial system and provides greater flexibility in banks operations Capital Market Capital market is the market for financial assets having a period of maturity of more than one year or of an indefinite period. Thus, capital market provides long-term resources needed by medium and large scale industries. The Indian capital market which had been lying dormant in the seventies up to mid eighties has witnessed an unprecedented boom and undergone sea change with a number of financial services and banking companies, merchant bankers, more stock exchanges, ventures capital funds, private sector mutual funds, foreign institutional investors, over-the-counter exchange, national stock exchange, credit rating services, custodial services, portfolio management services, non-resident investment, new regulations etc. emerging on the Indian capital scene. Before repeal of Capital Issues Control Act 1947, the entire working of the new issue market in India was governed by the Controller of Capital issues Control Act, 1947. The timing of the new issues by private sector companies, the composition of securities to be issued, interest (dividend) rates which can be offered on debentures and preference shares, the premium to be charged on securities were all subject to the regulation of the CCI. The repeal of Capital Issues Control Act, 1947 and the establishment of Securities Exchange board of India (SEBI) has been a milestone in the history of capital market in India. There is complete metamorphosis of the market system, policies and regulation with the birth of SEBI like allowing companies to fix the price of instruments, making guidelines for various issues involved in primary market and framing guidelines for various intermediaries of both primary and secondary market. The role of SEBI has changed from controlling to regulatory with investor protection as the primary motive.

What is meant by Secondary market? Secondary market refers to a market where securities are traded after being initially offered to the public in the primary market and/or listed on the Stock Exchange. Majority of the trading is done in the secondary market. Secondary market comprises of equity markets and the debt markets. What is the role of the Secondary Market? For the general investor, the secondary market provides an efficient platform for trading of his securities. For the management of the company, Secondary equity markets serve as a monitoring and control conduitby facilitating value-enhancing control activities, enabling implementation of incentive-based management contracts, and aggregating information (via price discovery) that guides management decisions. What is the difference between the Primary Market and the Secondary Market? In the primary market, securities are offered to public for subscription for the purpose of raising capital or fund. Secondary market is an equity-trading venue in which already existing/pre-issued securities are traded among investors. Secondary market could be either auction or dealer market. While stock exchange is the part of an auction market, Over-the-Counter (OTC) is a part of the dealer market.

Primary Market
The primary is that part of the capital markets that deals with the issuance of new securities. Companies, governments or public sector institutions can obtain funding through the sale of a new stock or bond issue. This is typically done through a syndicate of securities dealers. The process of selling new issues to investors is called underwriting. In the case of a new stock issue, this sale is an initial public offering (IPO). Dealers earn a commission that is built into the price of the security offering, though it can be found in the prospectus. Features of primary markets are:

This is the market for new long term capital. The primary market is the market where the securities are sold for the first time. Therefore it is also called New Issue Market (NIM). In a primary issue, the securities are issued by the company directly to investors. The company receives the money and issues new security certificates to the investors. Primary issues are used by companies for the purpose of setting up new business or for expanding or modernizing the existing business. The primary market performs the crucial function of facilitating capital formation in the economy. The new issue market does not include certain other sources of new long term external finance, such as loans from financial institutions. Borrowers in the new issue market may be raising capital for converting private capital into public capital; this is known as going public.

Methods of issuing securities in the primary market are: Initial public offering, Rights issue (for existing companies), and Preferential issue.

The secondary market is the financial market for trading of securities that have already been issued in an initial private or public offering. Alternatively, secondary market can refer to the market for any kind of used goods. The market that exists in a new security just after the new issue is often referred to as the aftermarket. Once a newly issued stock is listed on a stock exchange, investors and speculators can easily trade on the exchange, as market makers provide bids and offers in the new stock.

FINANCIAL INSTRUMENTS Money Market Instruments The money market can be defined as a market for short-term money and financial assets that are near substitutes for money. The term short-term means generally a period up to one year and near substitutes to money is used to denote any financial asset which can be quickly converted into money with minimum transaction cost. Some of the important money market instruments are briefly discussed below 1. Call/Notice Money 2. Treasury Bills 3. Term Money 4. Certificate of Deposit 5. Commercial Papers

1. Call /Notice-Money Market Call/Notice money is the money borrowed or lent on demand for a very short period. When money is borrowed or lent for a day, it is known as Call (Overnight) Money. Intervening holidays and/or Sunday are excluded for this purpose. Thus money, borrowed on a day and repaid on the next working day, (irrespective of the number of intervening holidays) is "Call Money". When money is borrowed or lent for more than a day and up to 14 days, it is "Notice Money". No collateral security is required to cover these transactions. 2. Inter-Bank Term Money Inter-bank market for deposits of maturity beyond 14 days is referred to as the term money market. The entry restrictions are the same as those for Call/Notice Money except that, as per existing regulations, the specified entities are not allowed to lend beyond 14 days. 3. Treasury Bills. Treasury Bills are short term (up to one year) borrowing instruments of the union government. It is an IOU of the Government. It is a promise by the Government to pay a stated sum after expiry of the stated period from the date of issue (14/91/182/364 days i.e. less than one year). They are issued at a discount to the face value, and on maturity the face value is paid to the holder. The rate of discount and the corresponding issue price are determined at each auction. 4. Certificate of Deposits Certificates of Deposit (CDs) is a negotiable money market instrument and issued in dematerialised form or as a Promissory Note, for funds deposited at a bank or other eligible financial institution for a specified time period. Guidelines for issue of CDs are presently governed by various directives issued by the Reserve Bank of India, as amended from time to time. CDs can be issued by (i) scheduled commercial banks excluding Regional Rural Banks (RRBs) and Local Area Banks (LABs) (ii) Select all-India Financial Institutions that have been permitted by RBI to raise shortterm resources within the umbrella limit fixed by RBI. Banks have the freedom to issue CDs depending on their requirements. 5. Commercial Paper CP is a note in evidence of the debt obligation of the issuer. On issuing commercial paper the debt obligation is transformed into an instrument. CP is thus an unsecured promissory note privately placed with investors at a discount rate to face value determined by market forces. CP is freely negotiable by endorsement and delivery.

A company shall be eligible to issue CP provided:(a) The tangible net worth of the company, as per the latest audited balance sheet, is not less than Rs. 4 crore; (b) The working capital (fund-based) limit of the company from the banking system is not less than Rs.4 crore and