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n of a set of inter-related activities and services

n its simple meaning the term ‘finance’ refers to monetary resources & the term ‘financing’ refers to the activity of providing required monetary resources to the needy persons and institutions. The term ‘financial system’ refers to a system that is concerned with the mobilization of the savings of the public and providing of necessary funds to the needy persons and institutions for enabling the production of goods and/or for provision of services. Thus, a financial system can be understood as a system that allows the exchange of funds between lenders, investors, and borrowers. In other words, the system that facilitates the movement of finance from the persons who have surplus funds to the persons who need it is called as financial system. It consists of complex, closely related services, markets, and institutions used to provide an efficient and regular linkage between investors and depositors. Financial systems operate at national, global, and firm-specific levels. It includes the public, private and government spaces and financial instruments which can relate to countless assets and liabilities. Components/Constituents/Elements/Parts of Financial System 1. Financial Assets 2. Financial Intermediaries/Financial Institutions 3. Financial Markets 4. Financial Rates of Return 5. Financial Instruments and 6. Financial Services Functions/Importance/Objectives/Advantages of Financial System 1. Provision of liquidity 2. Mobilization of savings 3. Size transformation/Capital formation 4. Maturity transformation 5. Risk transformation 6. Lowering of cost of transaction 7. Payment mechanism 8. Assisting new projects 9. Enable better decision making 10. Meet short and long term financial needs 11. Provide necessary finance to the Government 12. Accelerate the process of economic growth of the country Features/Characteristics of Financial System 1. Financial system acts as a bridge between savers and borrowers 2. It consists of a set of inter-related activities and services 3. It consists of both formal and informal financial sectors. The existence of both formal and informal system is also called as financial dualism. 4. It formulates capital, investment and profit generation 5. It is universally applicable at firm level, regional level, national level and international level 6. It consists of financial institutions, financial markets, financial services, financial instruments, financial practices and financial transactions. 2 | I n d i a n F i n a n c i a l S y s t e m D r . R . K . S r e e k a n t h FINANCIAL ASSETS Meaning of financial assets Financial assets refer to the cash or cash equivalents that are used for production or consumption or for further creation of assets. Cash, Bank Deposits, Shares, Debentures, Investment in Gold, Land & Buildings, Contractual right to receive cash or another financial asset, etc., are called as financial assets. Classification of Financial Assets Financial assets are classified in two ways 1. On the basis of marketability 2. On the basis of nature Classification of Financial Assets on the basis of marketability 1. Marketable – The financial assets that can be bought and sold are called as marketable financial assets. They include Shares, Government Securities, Bonds, Mutual Funds, Units of UTI, Bearer Debentures 2. Non-marketable – The financial assets that cannot be bought and sold are called as nonmarketable finance assets. They include Bank Deposits, Provident Funds, LIC Policies, Company Deposits, Post Office Certificates Classification of Financial Assets on the basis of nature 1. Money or Cash Asset – Coins, Currency Notes, Bank Deposits 2. Debt Asset – Debenture & Bonds 3. Stock Asset – Equity Shares & Preference Shares FINANCIAL INTERMEDIARIES/FINANCIAL INSTITUTIONS Different kinds of organizations/institutions which intermediate and facilitate financial transactions of both individual and corporate customers are called as financial intermediaries or financial institutions. Basically they are classified into two types: 1. Unorganized Sector 2. Organized Sector Unorganized Sector The sector that is not governed by any statutory or legal authority is known as unorganized sector. This sector consists of the individuals and institutions for whom there are no standardized rules and regulations governing their financial dealings. They are not under the supervision and control of RBI or any other regulatory body. This sector consists of the individuals and institutions like Local money lenders, Pawn brokers, Traders, Landlords, Indigenous bankers, etc., who lend money to needy persons and institutions. Organized Sector The sector that is governed by some statutory or legal authority is known as organized sector. This sector consists of the institutions like Commercial Banks, Non Banking Financial Institutions, etc. They are further classified into two: 1. Capital Market Intermediaries 2. Money Market Intermediaries Capital Market Intermediaries Capital Market refers to the market for long term finance. The intermediaries provide long term finance to individuals and corporate customers. IDBI, SFCs, LIC, GIC, UTI, MFs, EXIM BANK, NABARD, NHB, 3 | I n d i a n F i n a n c i a l S y s t e m D r . R . K . S r e e k a n t h NBFCs (Hire Purchasing, Leasing, Investment and Finance Companies) Government (PF, NSC) etc., are in the organized sector providing long term finance. Money Market Intermediaries Money Market refers to the market for short term finance. The intermediaries provide short term finance to individuals and corporate customers. RBI, Commercial Banks, Co-operative Banks, Post Office Savings Banks, Government (Treasury Bills) are in the organized sector providing short term finance. FINANCIAL MARKETS The group of individuals and corporate institutions dealing in financial transactions are termed as financial markets. The centres or arrangements that facilitate buying and selling of financial assets, claims and services are the constituents of financial market. Basically they are classified into two categories: 1. Unorganized Market 2. Organized Market Unorganized Market The sector that is not governed by any statutory or legal authority is known as unorganized sector. This sector consists of the individuals and institutions for whom there are no standardized rules and regulations governing their financial dealings. They are not under the supervision and control of RBI or any other regulatory body. Local money lenders, Pawn brokers, Traders, Landlords, Indigenous bankers, etc., who lend money are in the unorganized sector. Organized Market The sector that is governed by some statutory or legal authority is known as organized sector. This sector consists of the institutions for whom there are standardized rules and regulations governing their financial dealings. They are under the supervision and control of RBI and other statutory bodies. They are further classified into two: A. Capital Market B. Money Market C. Foreign Exchange Market A. Capital Market Capital Market refers to the market for long term finance. Financial assets which have a long or indefinite maturity period are dealt in this market. Capital Market is further classified into the following three: a) Industrial Securities Market b) Government Securities Market c) Long-term Loans Market a) Industrial Securities Market – The financial market where industrial securities like equity shares, preference shares, debentures, bonds, etc., are dealt with is called as Industrial Securities Market. In this market, the industrial concerns raise their capital and debts by issuing appropriate securities. This market is again classified into the following two viz., Primary Market and Secondary Market Primary Market – The financial market concerned with the fresh issue of industrial securities is called as primary market. It is also called as new issue market. In this market, industrial securities which are issued for the first time to the public are dealt. Secondary Market – The financial market concerned with the purchase and sale of already existing industrial securities is called as secondary market. In this market, industrial securities which are already held by the individuals and institutions are bought and sold. Generally, these securities are quoted in the stock exchanges. This market consists of all the stock exchanges recognized by the 4 | I n d i a n F i n a n c i a l S y s t e m D r . R . K . S r e e k a n t h Government of India. Securities Contracts (Regulation) Act, 1956 regulates the stock exchanges and Bombay Stock Exchange is the main stock exchange in India which leads the other stock exchanges. b) Government Securities Market or Gilt-edged Securities Market – The financial market where Government securities like stock certificates, promissory notes, bearer bonds, treasury bills, etc., are dealt with is called as Government Securities Market. The long term securities issued by the Central Government, State Governments, Semi-government authorities like City Corporations, Port Trusts, etc., Improvement Trusts, State Electricity Boards, All India and State level financial institutes and public sector enterprises are bought and sold in this market. c) Long-term Loans Market – The financial market where long-term loans are provided to the corporate customers is called as Long-term Loans Market. Development Banks and Commercial Banks play a major role in this market. This market is classified into three categories viz., Term loans market, Mortgages market and Financial guarantees market: Term loans market – This market consists of the industrial financing institutions which supply long term loan to corporate customers. They are created by the Government both at the national level and regional level. They provide term loans to corporate customers and also help them in identifying investment opportunities. They also encourage new entrepreneurs and support modernization efforts. IDBI, IFCI, ICICI, SFCs, etc., come under this market. Mortgages market – This market consists of the institutions which supply mortgage loan mainly to individuals. The term ‘mortgage’ refers to the transfer of interest in a specific immovable property to secure a loan. Financial guarantees market – This market consists of the institutions which provide financial guarantee to individuals and corporate customers. The term ‘guarantee’ refers to a contract whereby one person promises another person to discharge the liability of a third person in case of his default. There are different types of guarantees prominent among them are Performance guarantee and Financial guarantee. B. Money Market Money Market refers to the market for short term finance. Financial assets which have a short period of maturity are dealt in this market. Near money like Trade Bills, Promissory Notes, Short term Government Papers, etc., are traded in this market. Composition of money market (Financial instruments dealt in money market) – The money market comprises of the following: 1. Call money market 2. Commercial bills market 3. Treasury bills market 4. Short-term loan market Call money market – The market where finance is provided just against a call made by the borrower is called call money market. In this market finance is provided for an extremely short period of time. Commercial bills market – The market where finance is provided by discounting of commercial bills is called as commercial bills market. The term ‘commercial bills’ refer to the bills of exchange arising out of genuine trade transactions. Treasury bills market – The market where finance is provided against the treasury bills is called as treasury bills market. The term ‘treasury bill’ refers to the promissory notes or finance bills issued by the government for its short-term finance requirements. Short-term loans market – The market where finance is provided in the form of short term loans is called as short term loans market. The term ‘short-term’ refers to a period less than one year. 5 | I n d i a n F i n a n c i a l S y s t e m D r . R . K . S r e e k a n t h Commercial banks provide short term loans in the form of overdrafts and cash credits. These loans are given to meet the working capital requirements of traders and industrialists. C. Foreign Exchange Market The market where foreign currencies are bought and sold against domestic currency is called foreign exchange market. In other words, the system where the domestic currency is converted into foreign currency and vice-versa is called as foreign exchange market. FINANCIAL RATE OF RETURN The term ‘financial rate of return’ refers to the percentage of income generated from the financial assets throughout its effective life. For calculation of financial rate of return, two types of incomes are considered. The first type of income is the annual income generated i.e., dividend on shares or interest on securities. The second type of income is the capital appreciation. Capital appreciation means increase in the value of securities over and above the purchase price of the securities. Financial rate of return acts as a tool for investment decisions of the public and other financial institutions. The financial system should offer attractive rate of return on investments so that the investors would be ready to invest their surplus funds in the financial markets. The return on Government securities and bonds are generally less than the Commercial securities as the risk involved in Government securities is comparatively less. The central bank of the country fixes the key interest rates like CRR, SLR, REPO rates, Reverse REPO rates, etc. The rate of return on any security depends on the risk involved in the investment, the duration of the investment, the purpose for which the investment is utilized, the risk free rate of return, etc. The interest rate policy of the country is designed by the central bank to achieve the following objectives: 1. To enable the government to borrow funds at a lower rate of interest 2. To ensure stability by striking a balance between the economic growth and inflation 3. To mobilize savings in the economy 4. To support specific sector through concessional lending rates. Illustration Mr. A subscribes to the equity shares of RKS Ltd., on 1/4/2014 for Rs. 1,00,000. After receiving 15% dividend from the company, he sells the said equity shares for Rs. 1,20,000. What is the financial rate of return? Solution Investment value Rs. 1,00,000 Income generated = Dividend + Capital appreciation = Rs. 15,000 + Rs. 20,000 = Rs. 35,000 Financial rate of return = (Income generated / Investment) X 100 = (35,000 / 1,00,000) X 100 = 35% FINANCIAL INSTRUMENTS Financial instruments refer to the documents that represent financial claim. A financial claim is claim to the repayment of a certain amount of money at the end of a specified period along with interest or dividend. Shares, Government Securities, Bonds, Mutual Funds, Units of UTI, Debentures, Bank Deposits, Provident Funds, LIC Policies, Company Deposits, Post Office Certificates, etc., are some of the examples of financial instruments. These instruments are classified into two types, viz., Primary securities and Secondary securities. 6 | I n d i a n F i n a n c i a l S y s t e m D r . R . K . S r e e k a n t h Primary Securities – These are the financial instruments that are issued directly to the savers by the users of the funds. For example, shares or debentures issued by a joint stock company directly to the public and institutions are called as primary securities. Secondary Securities – These are the financial instruments that are issued to the savers by some intermediaries. For example, units issued by Unit Trust of India and other Mutual Fund Organizations are called as secondary securities FINANCIAL SERVICES Financial services refer to the activities of channelizing the flow of funds from the savers to the users. It involves the mobilization of savings of the persons and institutions who have surplus funds and allocating or lending them to the persons and institutions who are in need of such funds. The financial services are categorized into two groups, viz., Traditional services and Modern services 1. Traditional services refer to the services that the financial institutions are rendering from a very long time. They are further classified into two viz., a) Fund based services and b) Non-fund or Fee based services. 2. Modern services refer to the services that the financial institutions are rendering in the recent years. GROWTH OF FINANCIAL SYSTEM IN INDIA Until independence in the year 1947, there was no strong financial system in India. Private sector and unorganized financial intermediaries were playing the key role of financing the industry. They were not following any justifiable way in financing the trade and commerce. On the whole, the financial system was facing a chaotic condition. The growth of financial system in India since independence is discussed below:  Nationalization of Financial Institutions – After independence, with the adoption of mixed economy, the government started creating new financial institutions for the supply of finance for both industrial and agricultural purposes. For this purpose, some important financial institutions of those days were nationalized. The financial institutions that were nationalized over the years are as under: o In the year 1948, Reserve Bank of India (which was established in the year 1935 as a private sector central bank) was nationalized o In the year 1955, the then Imperial Bank of India was nationalized and renamed as State Bank of India o In the year 1956, 245 life insurance business entities (consisting of 154 life insurance companies, 16 foreign companies and 75 provident companies) were nationalized and merged to form Life Insurance Corporation of India. o In the year 1969, 14 Commercial Banks were nationalized o In the year 1972, 107 general insurance business entities (consisting of 55 Indian insurance companies and 52 other general insurance operations of other companies) were nationalized and merged to form General Insurance Corporation of India o In the year 1980 another 6 Commercial Banks were nationalized  Establishment of Unit Trust of India – The Unit Trust of India (UTI) was established in the year 1964 to strengthen the Indian financial system and supply institutional credit to industries. It was entrusted with the work of mobilization of the savings of the public and provision of credit facility to institutions for productive purposes. In recent years, it has established the following

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