Chapter 2 The Financial System

Chapter 2 THE FINANCIAL SYSTEM

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OUTLINE • Functions of the Financial System • Financial Assets • Financial Markets • Financial Market Returns • Financial Intermediaries • Regulatory Infrastructure  Centre for Financial Management , Bangalore

THE FINANCIAL SYSTEM Financial Institutions

Funds Deposits/Shares

Commercial Banks Insurance Companies Mutual Funds Provident Funds Non-Banking Financial Companies

Suppliers of Funds

Funds Loans

Demanders of Funds

Individuals Businesses Governments

Individuals Businesses Governments

Funds

Financial Markets Money Market Capital Market

Funds Securities

Securities  Centre for Financial Management , Bangalore

FUNCTIONS OF THE FINANCIAL SYSTEM • Payment System • Pooling of Funds • Transfer of Resources • Risk Management • Price Information for Decentralised Decision Making • Dealing with Incentive Problem  Centre for Financial Management , Bangalore

FUNCTIONS OF THE FINANCIAL SYSTEM Payment System Depository financial intermediaries such as banks are the pivot of the payment system. Credit card companies play a supplementary role. Pooling of Funds Financial markets and intermediaries facilitate the pooling of the household savings for financing business. Transfer of Resources The financial system facilitates the efficient life-cycle allocations of household consumption, the efficient allocation of physical capital to its most productive use, and the efficient separation of ownership from management.  Centre for Financial Management , Bangalore

FUNCTIONS OF THE FINANCIAL SYSTEM Risk Management A well-developed financial system offers a variety of instruments that enable economic agents to pool, price, and exchange risk The three basic methods of managing risk are : hedging, diversification, and insurance Price Information for Decentralised Decision Making Interest rates and security prices are used by households in their consumption-saving-investment decisions and by firms in their investment and financing decisions

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FUNCTIONS OF THE FINANCIAL SYSTEM Dealing with Incentive Problems Information asymmetry leads to moral hazard and adverse selection, which are broadly referred to as agency problems. Financial intermediaries like banks and venture capital organizations can solve the problem of informational asymmetry by handling sensitive information discreetly and developing a reputation for profitable activity

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FINANCIAL SECTOR REFORMS IN INDIA The financial sector reforms initiated from the early 1990s have focused on the following objectives: •

Removal of financial repression.

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Creation of an efficient, productive, and profitable financial sector.

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Evolution of market-determined interest rates.

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Granting of operational and functional autonomy to institutions.

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Opening of operational and functional autonomy to institutions.

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Opening up of the external sector in a calibrated fashion.

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Maintenance of financial stability in face of domestic and external disturbances.  Centre for Financial Management , Bangalore

FINANCIAL ASSETS Financial assets are intangible assets that represent claims to future cash flows. The terms financial asset, instrument, or security are used interchangeably Examples : • A 10-year bond issued by the GOI carrying an interest rate of 7 percent. • Equity shares issued by TCS to the general investing public through an initial public offering. • Call options granted by WIPRO to its employees.  Centre for Financial Management , Bangalore

FINANCIAL MARKETS A financial market is a market for creation and exchange of financial assets. Financial markets play a very pivotal role in allocating resources in the economy by performing three important functions as they : • Facilitate price discovery. • Provide liquidity. • Reduce the cost of transacting.  Centre for Financial Management , Bangalore

FUNCTIONS OF FINANCIAL MARKETS Facilitate Price Discovery The continual interaction among numerous buyers and sellers who participate in financial markets helps in establishing the prices of financial assets Provide Liquidity Thanks to the liquidity provided by financial markets, it is possible for companies (and other entitities) to raise long-term funds from investors with short-term horizons Reduce the Costs of Transacting Financial markets considerably reduce the following costs of transacting • Search cost • Information cost  Centre for Financial Management , Bangalore

CLASSIFICATION OF FINANCIAL MARKETS DEBT MARKET NATURE OF CLAIM EQUITY MARKET MONEY MARKET MATURITY OF CLAIM CAPITAL MARKET PRIMARY MARKET SEASONING OF CLAIM SECONDARY MARKET CASH OR SPOT MARKET TIMING OF DELIVERY FORWARD OR FUTURES MARKET EXCHANGE-TRADED MARKET ORGANISATIONAL STRUCTURE

OVER-THE-COUNTER MARKET

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FINANCIAL MARKET RETURNS • Interest Rate Function of the unit of account, maturity, and default risk • Rate of Return on Risky Assets Cash dividend Ending price – Beginning price r= + Beginning price Beginning price Dividend yield

Capital yield

• Inflation and Real Interest Rate 1 + Nominal rate 1 + Real rate = 1 + Inflation rate  Centre for Financial Management , Bangalore

DETERMINANTS OF RATES OF RETURN • Expected Productivity of Capital • Degree of Uncertainty about the Productivity of Capital • Time Preferences of People • Degree of Risk Aversion

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EQUILIBRIUM IN FINANCIAL MARKETS (a) Supply and demand for loanable funds and determination of interest rate Interest rate Sf (lending) ie

S’f

i’e Df (borrowing) 0

A B Amount of loanable funds

 Centre for Financial Management , Bangalore

(b) Supply and demand for securities and determination of prices

Price

SS (borrowing)

P’e Pe D’s Ds (lending)

0

A’ B’ Amount of securities  Centre for Financial Management , Bangalore

FINANCIAL INTERMEDIARIES Reserve Bank of India

Commercial banks

Public sector banks

Developmental financial institutions

All India institutions

Insurance companies

Life Insurance Corporation of India

Private sector insurance companies

Private sector banks

State level institutions

Mutual funds

Other public sector financial institutions

General Insurance Corporation of India

POSB

Non-banking financial corporations

Unit Trust of India

Public sector firms

Other mutual funds

Private sector firms

NABARD

NHB

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RATIONALE FOR FINANCIAL INTERMEDIARIES • Diversification • Lower Transaction Cost • Economies of Scale • Confidentiality • Signalling  Centre for Financial Management , Bangalore

RATIONALE FOR FINANCIAL INTERMEDIARIES Diversification The pool of funds mobilised by financial intermediaries is invested in a broadly diversified portfolio of assets (loans, stocks, bonds and so on). Lower Transaction Cost The transaction cost in percentage terms decreases as the transaction size increases. Economies of Scale Financial institutions enjoy economies of scale Confidentiality Information shared with financial intermediaries may be kept confidential whereas information disclosed to numerous individual investors is in public domain. Signalling Financial intermediaries can pick up and interpret signals and cues better. So they perform a signalling function for the investment community.  Centre for Financial Management , Bangalore

REGULATARY INFRASTRUCTURE • RESERVE BANK OF INDIA • SEBI

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KEY TRENDS IN THE INDIAN FINANCIAL SYSTEM • Market-determined interest rates and greater volatility of interest rates • Emergence of universal banks • Emphasis on prudential regulation and supervision • Gradual integration with the global financial system • Increase in financial innovation  Centre for Financial Management , Bangalore

SUMMING UP • The financial system – consisting of a variety of institutions, markets, and instruments related in a systematic manner – provides the principal means by which savings are transformed into investments. • The financial system provides a payment mechanism, enables the pooling of funds, facilitates the management of uncertainty, generates information for decentralised decision making, and helps in dealing with informational asymmetry. • Financial assets represent claims against the future income and wealth of others. Financial liabilities, the counterparts of financial assets, represent promises to pay some portion of prospective income and wealth to others. • The important financial assets and liabilities in our economy are money, demand deposit, short-term debt, intermediate-term debt, long-term debt, and equity stock. • A financial market is a market for creation and exchange of financial assets. Financial markets facilitate price discovery, provide liquidity, and reduce the cost of transacting.  Centre for Financial Management , Bangalore

• There are different ways of classifying financial markets. The important bases for classification are: type of financial claims, maturity of claims, new issues versus outstanding issues, timing of delivery, and nature of organisational structure. • The interest rate on any type of loan (or fixed income security) depends on several factors, the most important being the unit of account, the maturity, and the default risk. • Just as a distinction is made between nominal and real prices, so too a distinction is made between nominal and real interest rates. The nominal interest rate on a bond is the rate of return in nominal terms whereas the real rate is the nominal rate adjusted for the inflation factor. • The principal determinants of rates of return in a market economy are : expected productivity of capital; degree of uncertainty characterising the productivity of capital; time preferences of people; and degree of risk-aversion.

• An equilibrium price clears the market for loanable funds. It is expressed as an interest rate - the amount per rupee per annum that the lender gets and the borrower pays.  Centre for Financial Management , Bangalore

• Despite a good deal of deregulation in recent years, interest rates in India continue to be substantially regulated. • Financial intermediaries are firms that provide services and products that customers may not be able to get more efficiently by themselves in financial markets. • Financial intermediaries seem to offer several advantages : diversification, lower transaction cost, economies of scale, confidentiality, and signaling benefit. • The major financial intermediaries in India are commercial banks, developmental financial institutions, insurance companies, mutual funds, non-banking financial companies, and merchant banks. • As a maker and enforcer of laws in a society, the government has the responsibility for regulating the financial system. The two major regulatory arms of the Government of India are the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI).

 Centre for Financial Management , Bangalore