An understanding of the financial system requires an understanding of the following concepts:
- Financial assets
- Financial intermediaries
- Financial markets
- Financial rates of return
- Financial instruments
In any financial transaction, there should be a creation or transfer of financial assets. Hence, the basic product of any financial system is the financial asset. A financial asset is one which is used for production or consumption or for further creation of assets.
Classification of Financial Assets
Financial assets can be classified differently under different circumstances. One such classification is:
- Marketable assets
- Non-marketable assets
Marketable Assets: Marketable assets are those which can be easily transferred fromone person to another without much hindrance. Examples are shares of listed companies, Government securities, bonds of public sector undertakings etc.
Non-Marketable Assets: On the other hand, if the assets cannot be transferred easily,they come under this category. Examples are bank deposits, provident, funds, pension funds, National Savings Certificates, insurance policies etc.
Yet another classification is as follows:
- Money or cash asset
- Debt asset
- Stock asset
The term financial intermediary includes all kinds of organizations which intermediate and facilitate financial transactions of both individual and corporate customers
- Capital market intermediaries
- Money market intermediaries
Generally speaking, there is no specific place or location to indicate a financial market. Wherever a financial transaction takes place, it is deemed to have taken place in the financial market.
Classification of Financial Markets
- Unorganised Markets
In these markets there are a number of money lenders, indigenous bankers, traders etc., who lend money to the public. Indigenous bankers also collect deposits from the public.
- Organised Markets
In the organized markets, there are standardized rules and regulations governing their financial dealings.
These organized markets can be further classified into two. They are :
- Capital market
- Money market
Capital Market : The capital market is a market for financial assets which have a longor indefinite maturity. Generally, it deals with long term securities which have a maturity period of above one year. Capital market may be further divided into three namely :
- Industrial securities market
- Government securities market and
- Long term loans market
Industrial securities market
As the very name implies, it is a market for industrial securities namely: (i) Equity shares or ordinary shares, (ii) Preference shares, and (iii) Debentures or bonds. It is a market where industrial concerns raise their capital or debt by issuing appropriate instruments. It can be further subdivided into two. They are :
- Primary market or New issue market
- Secondary market or Stock exchange
Government Securities Market
It is otherwise called Gilt-Edged securities market. It is a market where Government securities are traded. In India there are many kinds of Government Securities-short term and long term.
Long Term Loans Market
Development banks and commercial banks play a significant role in this market by supplying long term loans to corporate customers. Long term loans market may further be classified into:
- Term loans market
- Mortgages market
- Financial Guarantees market
Importance of Capital Market
Absence of capital market acts as a deferent factor to capital formation and economic growth. Resources would remain idle if finance is not funnelled through capital market.
Money market is a market for dealing with financial assets and securities which have a maturity period of up to one year. In other words, it is a market for purely short term funds. The money market may be subdivided into four. They are:
- Call money market
- Commercial bills market
- Treasury bills market
- Short term loan market
Call Money Market: The call money market is a market for extremely short periodloans say one day to fourteen days. So, it is highly liquid.
Commercial Bills Market: It is a market for bills of exchange arising out of genuinetrade transactions. In the case of credit sale, the seller may draw a bill of exchange on the buyer.
Treasury Bills Market: It is a market for treasury bills which have ‘short-term’maturity.
Short-Term Loan Market: It is a market where short-term loans are given to corporatecustomers for meeting their working capital requirements.
Foreign Exchange Market
The term foreign exchange refers to the process of converting home currencies into foreign currencies and vice versa.
Functions: The most important functions of this market are :
- To make necessary arrangements to transfer purchasing power from one country to another.
- To provide adequate credit facilities for the promotion of foreign trade.
- To cover foreign exchange risks by providing hedging facilities.
Financial Rates of Return
Most households in India still prefer to invest on physical assets like land, buildings, gold, silver etc. But, studies have shown that investment in financial assets like equities in capital market fetches more return than investments on gold. It is imperative that one should have some basic knowledge about the rate of return on financial assets also.The return on Government securities and bonds are comparatively less than on corporate securities due to lower risk involved therein.
Recent Trends: With a view to bringing the interest rates nearer to the free marketrates, the Government has taken the following steps:
- The interest rates on company deposits are freed.
- The interest rates on 364 days Treasury Bills are determined by auctions and they are expected to reflect the free market rates.
- The coupon rates on Government loans have been revised upwards so as to be market oriented.
- The interest rates on debentures are allowed to be fixed by companies depending upon the market rates.
- The maximum rates of interest payable on bank deposits (fixed) are freed for deposits of above one year.
Thus, all attempts are being taken to adopt a realistic interest rate policy so as to give positive return in real terms adjusted for inflation. The proper functioning of any financial system requires a good interest rate structure.
Financial instruments refer to those documents which represent financial claims on assets.
- Primary or direct securities.
- Secondary or indirect securities.
Primary Securities: These are securities directly issued by the ultimate investors to theultimate savers, e.g. shares and debentures issued directly to the public.
Secondary Securities: These are securities issued by some intermediaries calledfinancial intermediaries to the ultimate savers, e.g. Unit Trust of India and mutual funds issue securities in the form of units to the public and the money pooled is invested in companies.
DEVELOPMENT OF FINANCIAL SYSTEM IN INDIA
Some serious attention was paid to the development of a sound financial system in India only after the launching of the planning era in the country. At the time of Independence in 1947, there was no strong financial institutional mechanism in the country.
Nationalisation of Financial Institution
As we know that the RBI is the leader of the financial system. But, it was established as a private institution in 1935. It was nationalized in 1948. It was followed by the nationalization of the Imperial Bank of India in 1956 by renaming it as State Bank of India. In the same year, 245 Life Insurance Companies were brought under Government control by merging all of them into a single corporation called Life Insurance Corporation of India.
Starting of Unit Trust of India
Another landmark in the history of development of our financial system is the establishment of new financial institutions to strengthen our system and to supply institutional credit to industries.
Establishment of Development Banks
Many development banks were started not only to extend credit facilities to financial institutions but also to render advisory services.
Institution for Financing Agriculture
In 1963, the RBI set up the Agricultural Refinance and Development Corporation (ARDC) to provide refinance support to banks to finance major development projects such as minor irrigation, farm mechanization,, land development, horticulture, daily development, etc.
Institution for Foreign Trade
The Export and Import Bank of India (EXIM Bank) was set up on January 1, 1982 to take over the operations of International Finance wing of the IDBI. Its main objective is to provide financial assistance to exporters and importers
Institution for Housing Finance
The National Housing Bank (NHB) has been set up on July 9, 1988 as an apex institution to mobilize resources for the housing sector and to promote housing finance institutions both at regional and local levels
Stock Holding Corporation of India Ltd. (SHCIL)
Recently in 1987 another institution viz., Stock Holding Corporation of India Ltd. was set up to tone up the stock and capital markets in India.
Mutual Funds Industry
Mutual funds refer to the funds raised by financial service companies by pooling the savings of the public and investing them in a diversified portfolio.
Venture Capital Institutions
Venture capital is another method of financing in the form of equity participation. A venture capitalist finances a project based on the potentialities of a new innovative project
Credit Rating Agencies
Of late, many credit rating agencies have been established to help investors to make a decision of their investment in various instruments and to protect them from risky ventures.
Multiplicity of Financial Instruments
The expansion in size and number of financial institutions has consequently led to a considerable increase in the financial instruments also.
The Indian financial system has been well supported by suitable legislative measures taken by the Government then and there for its proper growth and smooth functioning.
Weaknesses of Indian Financial System
After the introduction of planning, rapid industrialization has taken place. It has in turn led to the growth of the corporate sector and the Government sector.
Lack of Co-ordination between different Financial Institutions
There are a large number of financial intermediaries. Most of the vital financial institutions are owned by the Government.
Monopolistic Market Structures
In India some financial institutions are so large that they have created a monopolistic market structures in the financial system.
Dominance of Development Banks in Industrial Financing
The development banks constitute the backbone of the Indian financial system occupying an important place in the capital market.
Inactive and Erratic Capital Market
The important function of any capital market is to promote economic development through mobilization of savings and their distribution to productive ventures.
- Imprudent Financial Practice
The dominance of development banks has developed imprudent financial practice among corporate customers.
A system that aim at establishing and providing a regular smooth, efficient and cost effective linkage between depositors and investors in known as financial system. A financial system companies of financial institutions, financial services, financial markets and financial instruments. These constituents are closely related and work in conjunction with each other’s.