FMI

COM 1056: FINANCIAL MARKETS AND INSTITUTIONS

UNIT – 01

 Financial System

1.1 Concept of Financial System:

A system that aims at establishing and providing a regular, smooth, efficient and cost-effective linkage between depositors and investors is known as Financial System. Financial System intermediates between the flow of funds belonging to those who save part of their income and those who invest in productive asset. It is a complex, well integrated, set of systems of financial institution, financial market, financial instruments and financial services which allocate the funds efficiently and effectively. A financial system plays a vital role in the economic growth of a country. It intermediates between the flow of funds belonging to those who save a part of their income and those who invest in productive assets. It mobilises and usefully allocates scarce resources of a country. A financial system is a complex, well-integrated set of sub-systems of financial institutions, markets, instruments, and services which facilitates the transfer and allocation of funds, efficiently and effectively. 

The formal financial system consists of four components:

> Financial institutions. > Financial markets > Financial instruments

> Financial services The financial system acts as a connecting link between savers of money and users of money and thereby promotes faster economic and industrial growth. Thus, financial system may be defined as a set of markets and institutions to facilitate the exchange of assets and risks.” Efficient functioning of the financial system enables proper flow of funds from investors to productive activities which in turn facilitates investment.

1.2 Functions of a Financial System: 

1) Mobilise and allocate savings: One of the important functions of a financial system is to link the savers and investors and, thereby, help in mobilising and allocating the savings efficiently and effectively. By acting as an efficient conduit for allocation of resources, it permits continuous up gradation of technologies for promoting growth on a sustained basis. 

2) Monitor corporate performance: A financial system not only helps in selecting projects to be funded but also inspires the operators to monitor the performance of the investment. Financial markets and institutions help to monitor corporate performance and exert corporate control through the threat of hostile takeovers for underperforming firms. 

3) Provide payment and settlement systems: It provides a payment mechanism for the exchange of goods and services and transfers economic resources through time and across geographic regions and industries. Payment and settlement systems play an important role to ensure that funds move safely. quickly, and in a timely manner. An efficient payment and settlement system contribute to the operating and allocation efficiencies of the financial system and thus, overall economic growth. Payment and settlement systems serve an important role in the economy as the main arteries of the financial sector. Banks provide this mechanism by offering a means of payment facility based upon cheques, promissory notes, and credit and debit cards. This payment mechanism is now increasingly through electronic means. The clearing and settlements mechanism of the stock markets is done through depositories and clearing corporations.

4) Optimum allocation of risk-bearing and reduction: One of the most important functions of a financial system is to achieve optimum allocation of risk bearing. It limits, pools, and trades the risks involved in mobilising savings and allocating credit. An efficient financial system aims at containing risk within acceptable limits. It reduces risk by laying down rules governing the operation of the system. Risk reduction is achieved by holding diversified port folios and screening of borrowers. Market participants gain protection from unexpected losses by buying financial insurance services. Risk is traded in the financial markets through financial instruments such as derivatives. Derivatives are risk shifting devices, they shift risk from those who have it but may not want it to those who are willing to take it. 

5) Disseminate price related information: A financial system also makes available price-related information which is a valuable assistance to those who need to take economic and financial decisions. Financial markets disseminate information for enabling participants to develop an informed opinion about investment, disinvestment, reinvestment, or holding a particular asset. This information dissemination enables a quick valuation of financial assets. Moreover, by influencing the market price of a firm's debt and equity instruments, this process of valuation guides the management as to whether their actions are consistent with the objective of shareholder wealth maximisation. In addition, a financial system also minimises situations where the information is asymmetric and likely to affect motivations among operators when one party has the information and the other party does not. It also reduces the cost of gathering and analysing information to assist operators in taking decisions carefully. 

6) Offer portfolio adjustment facility: A financial system also offers portfolio adjustment facilities. These are provided by financial markets and financial intermediaries such as banks and mutual funds. Portfolio adjustment facilities include services of providing a quick, cheap and reliable way of buying and selling a wide variety of financial assets. 

7) Lower the cost of transactions: A financial system helps in the creation of a financial structure that lowers the cost of transactions. This has a beneficial influence on the rate of return to savers. It also reduces the cost of borrowing. Thus, the system generates an impulse among the people to save more. 

8) Promote the process of financial deepening and broadening: A well-functioning financial system helps in promoting the process of financial deepening and broadening. Financial deepening refers to an increase of financial assets as a percentage of the Gross Domestic Product (GDP). Financial depth is an important measure of financial system development as it measures the size of the financial intermediary sector. Depth equals the liquid liabilities of the financial system (currency plus demand and interest-bearing liabilities of banks and non-bank financial intermediaries divided by the GDP). Financial broadening refers to building an increasing number and variety of participants and instruments. 

1.3 Components and Structure of Financial System: 

1.3.1 Formal and Informal Financial Sectors: The financial systems of most developing countries are characterised by coexistence and cooperation between the formal and informal financial sectors. This coexistence of these two sectors is commonly referred to as 'financial dualism.' The formal financial sector is characterised by the presence of an organised, institutional, and regulated system which caters to the financial needs of the modern spheres of economy: the informal financial sector is an unorganised, non-institutional, and non-regulated system dealing with the traditional and rural spheres of the economy.

The informal financial sector has emerged as a result of the intrinsic dualism of economic and social structures in developing countries, and financial repression which inhibits the certain deprived sections of society from accessing funds. The informal system is characterised by flexibility of operations and interface relationships between the creditor and the debtor. The advantages are: low transaction costs, minimal default risk, and transparency of procedures. Due to these advantages, a wide range and higher rates of interest prevail in the informal sector. An interpenetration is found between the formal and informal systems in terms of operations, participants, and nature of activities which in turn, have led to their coexistence. A high priority should be accorded to the development of an efficient formal financial system as it can offer lower intermediation costs and services to a wide base of savers and entrepreneurs. 

Informal Financial System Advantages and Disadvantages 

 Advantages:

i. Low transaction costs

ii. Minimum default risk

iii. Transparency of procedures

Disadvantages :

i. Wide range of interest rates

ii. Higher rates of interest

iii. Unregulated

1.3.2 The Indian Financial System The Indian financial system can also be broadly classified into the formal (organised) financial system and the informal (unorganised) financial system. The formal financial system comes under the purview of the Ministry of Finance (MoF), the Reserve Bank of India (RBI), the Securities and Exchange Board of India (SEBI), and other regulatory bodies. 

The informal financial system consists of Individual moneylenders such as neighbours, relatives, landlords, traders, and storeowners. > Groups of persons operating as 'funds' or 'associations. These groups function under a system of their own rules and use names such as 'fixed fund,' association,' and 'saving club.' Partnership firms consisting of local brokers, pawnbrokers, and non-bank financial intermediaries such as finance, investment, and chit-fund companies. In India, the spread of banking in rural areas has helped in enlarging the scope of the formal financial system. 

1.3.2.1 Components of the Formal Financial System