Unit One – An Overview of the Financial System

The economic development of any country depends upon the existence of a well organized financial
system. It is the financial system which supplies the necessary financial inputs for the production of
goods and services which in turn promotes the well being and standard of living of the people of a
country. Thus, the ‘financial system’ is a broader term which brings under its fold the financial markets
and the financial institutions which support the system. The end-users of the system are people and firms
whose desire is to lend and to borrow.

Faced with a desire to lend or borrow, the end-users of most financial systems have a choice between
three broad approaches. Firstly, they may decide to deal directly with one another, though this, as we
shall see, is costly, risky, inefficient and, consequently, not very likely. More typically they may decide
to use one or more of many organized markets. In these markets, lenders buy the liabilities issued by
borrowers. If the liability is newly issued, the issuer receives funds directly from the lender. More
frequently, however, a lender will buy an existing liability from another lender. In effect, this refinances
the original loan, though the borrower is completely unaware of this ‘secondary’ transaction. The best-
known markets are the stock exchanges in major financial centers such as London, New York and
Tokyo. These and other markets are used by individuals as well as by financial and non-financial firms.

Alternatively, borrowers and lenders may decide to deal via institutions or ‘intermediaries’. In this case
lenders have an asset – a bank or building society deposit, or contributions to a life assurance or pension
fund – which cannot be traded but can only be returned to the intermediary. Similarly, intermediaries
create liabilities, typically in the form of loans, for borrowers. These two remain in the intermediaries’
balance sheets until they are repaid. Intermediaries themselves will also make use of markets, issuing
securities to finance some of their activities and buying shares and bonds as part of their asset portfolio

The major assets traded in the financial system are money and monetary assets. The responsibility of the
financial system is to mobilize the savings in the form of money and monetary assets and invest them to
productive ventures. An efficient functioning of the financial system facilitates the free flow of funds to
more productive activities and thus promotes investment. Thus, the financial system provides the
intermediation between savers and investors and promotes faster economic development.
1.1. Definition of financial system

Definition

Financial system is a system that aims at establishing and providing smooth, regular, efficient and
effective linkage between savers (depositors) and investors (borrowers). It is a set of complex and
closely connected instructions, practices, agents and claims related to the financial aspects of the
economy.

1.1.2 The role of financial system in the economy

The following are the roles of financial system in the economic development of a country.
1. Savings-investment relationship
To attain economic development, a country needs more investment and production. This can happen
only when there is a facility for savings. As, such savings are channelized to productive resources in the
form of investment. Here, the role of financial institutions is important, since they induce the public to
save by offering attractive interest rates. These savings are channelized by lending to various business
concerns which are involved in production and distribution.

2. Financial systems help in growth of capital market

Any business requires two types of capital namely, fixed capital and working capital. Fixed capital is
used for investment in fixed assets, like plant and machinery. While working capital is used for the day-
to-day running of business. It is also used for purchase of raw materials and converting them into
finished products.

 Fixed capital is raised through capital market by the issue of debentures and shares. Public and
other financial institutions invest in them in order to get a good return with minimized risks.
 For working capital, we have money market, where short-term loans could be raised by the
businessmen through the issue of various credit instruments such as bills, promissory notes, etc.
Foreign exchange market enables exporters and importers to receive and raise funds for settling
transactions. It also enables banks to borrow from and lend to different types of customers in various
foreign currencies. The market also provides opportunities for the banks to invest their short term idle
funds to earn profits. Even governments are benefited as they can meet their foreign exchange
requirements through this market.

3. Government Securities market

Financial system enables the state and central governments to raise both short-term and long-term funds
through the issue of bills and bonds which carry attractive rates of interest along with tax concessions.
The budgetary gap is filled only with the help of government securities market. Thus, the capital
market, money market along with foreign exchange market and government securities market enable
businessmen, industrialists as well as governments to meet their credit requirements. In this way, the
development of the economy is ensured by the financial system.

4. Financial system helps in Infrastructure and Growth

Economic development of any country depends on the infrastructure facility available in the country. In
the absence of key industries like coal, power and oil, development of other industries will be hampered.
It is here that the financial services play a crucial role by providing funds for the growth of infrastructure
industries. Private sector will find it difficult to raise the huge capital needed for setting up infrastructure
industries. For a long time, infrastructure industries were started only by the government in India. But
now, with the policy of economic liberalization, more private sector industries have come forward to
start infrastructure industry. The Development Banks and the Merchant banks help in raising capital for
these industries.

5. Financial system helps in development of Trade

The financial system helps in the promotion of both domestic and foreign trade. The financial institutions
finance traders and the financial market helps in discounting financial instruments such as bills. Foreign
trade is promoted due to per-shipment and post-shipment finance by commercial banks. They also issue
Letter of Credit in favor of the importer. Thus, the precious foreign exchange is earned by the country
because of the presence of financial system. The best part of the financial system is that the seller or the
buyer does not meet each other and the documents are negotiated through the bank. In this manner, the
financial system not only helps the traders but also various financial institutions. Some of the capital
goods are sold through installment system, both in the domestic and foreign trade. As a result of all
these, the growth of the country is speeded up.
6. Employment Growth is boosted by financial system
The presence of financial system will generate more employment opportunities in the country. The
money market which is a part of financial system provides working capital to the businessmen and
manufacturers due to which production increases, resulting in generating more employment
opportunities. With competition picking up in various sectors, the service sector such as sales, marketing,
advertisement, etc., also pick up, leading to more employment opportunities. Various financial services
such as leasing, factoring, merchant banking, etc., will also generate more employment. The growth of
trade in the country also induces employment opportunities. Financing by Venture capital provides
additional opportunities for techno-based industries and employment.
7. Venture Capital
The economic development of a country will be rapid when more ventures are promoted which
require modern technology and venture capital. Venture capital cannot be provided by
individual companies as it involves more risks. It is only through financial system, more
financial institutions will contribute a part of their investable funds for the promotion of new
ventures. Thus, financial system enables the creation of venture capital.

8. Financial system ensures balanced growth

Economic development requires a balanced growth which means growth in all the sectors
simultaneously. Primary sector, secondary sector and tertiary sector require adequate funds for their
growth. The financial system in the country will be geared up by the authorities in such a way that the
available funds will be distributed to all the sectors in such a manner, that there will be a balanced
growth in industries, agriculture and service sectors.

9. Financial system helps in fiscal discipline and control of economy

It is through the financial system, that the government can create a congenial business atmosphere so that
neither too much of inflation nor depression is experienced. The industries should be given suitable
protection through the financial system so that their credit requirements will be met even during the
difficult period. The government on its part can raise adequate resources to meet its financial
commitments so that economic development is not hampered. The government can also regulate the
financial system through suitable legislation so that unwanted or speculative transactions could be
avoided. The growth of black money could also be minimized.

10. Financial system’s role in balanced regional development

Through the financial system, backward areas could be developed by providing various concessions or
sops. This ensures a balanced development throughout the country and this will mitigate political or any
other kind of disturbances in the country. It will also check migration of rural population towards towns
and cities.

11. Role of financial system in attracting foreign capital

Financial system promotes capital market. A dynamic capital market is capable of attracting funds both
from domestic and abroad. With more capital, investment will expand and this will speed up the
economic development of a country.

12. Financial system’s role in Economic Integration

Financial systems of different countries are capable of promoting economic integration. This means that
in all those countries, there will be common economic policies, such as common investment, trade,
commerce, commercial law, employment legislation, old age pension, transport co-ordination, etc. We
have a standing example of European Common Market which has gone to the extent of creating a
common currency, representing several countries in Western Europe.

13. Role of financial system in Political stability

The political conditions in all the countries with a developed financial system will be stable.
Unstable political environment will not only affect their financial system but also their
economic development.

14. Financial system helps in Uniform interest rates

The financial system is capable of bringing a uniform interest rate throughout the country by
which there will be balanced movement of funds between centers which will ensure availability
of capital for all kinds of industries.

15. Financial system role in Electronic development

Due to the development of technology and the introduction of computers in the financial
system, the transactions have increased manifold bringing in changes for the all round
development of the country. The promotion of World Trade Organization (WTO) has further
improved international trade and the financial system in all its member countries.

1.2 Financial Assets

In any financial transaction, there should be a creation or transfer of financial asset. Hence, the basic
product of any financial system is the financial asset. Financial assets are intangible assets where
typically the future benefits come in the form of a claim to future cash. Another term used for a financial
asset is a financial instrument. Certain types of financial instruments are referred to as securities and
generally include stocks and bonds. For every financial instrument there is a minimum of two parties.
The party that has agreed to make future cash payments is called the issuer; and the party that owns the
financial instrument and therefore the right to receive the payments made by the issuer is referred to as
the investor.

Unlike real assets, financial assets do not represent a society’s wealth; do not contribute directly to the
productive capacity of the economy instead they are claims to the income generated by real assets or
claims on the income from the government. They are a means by which individuals hold their claims on
real assets.
 1.2.1 Real Assets Vs Financial Assets

Real Assets

A real asset is anything that generates a flow of goods or services over time. The material wealth of a
society is determined ultimately by the productive capacity of its economy. i.e. the goods and services
that can be provided to its members. This productive capacity is a function of the real assets of the
economy. Real assets need not be tangible. Both physical and human assets together generate the entire
spectrum of output produced and consumed by the society. Examples are land, building, knowledge,
machines, inventions, business plans, goodwill, reputation, etc

Distinction between real assets and financial assets

 Real assets are income-generating assets, whereas financial assets are the allocation of income or
wealth among investors.
 Real assets appear only on the asset side of the balance sheet, whereas financial assets appear on
both sides of balance sheets.
 i.e. Your financial claim on a firm is an asset, but the firm's issuance of that claim
is the firm's liability.
 Thus, When we aggregate overall balance sheets, financial assets will cancel out,
leaving only the sum of real assets as the net wealth of the aggregate
 Financial assets are created and destroyed in the ordinary course of doing business. For example,
when a loan is paid off, both the creditor's claim (a financial asset) and the debtor's obligation (a
financial liability) cease to exist.
 Whereas real assets are destroyed only by accident or by wearing out over time.

1.2.2 Role and Properties of Financial Assets

The following are the properties of Financial Assets, which distinguish them from Physical and
Intangible Assets:

1.      Currency:

Financial Assets are exchange documents with an attached value. Their values are dominated in currency
units determined by the government of an economy.

2.      Divisibility
Financial Instruments are divisible into smaller units. The total value is represented in terms of divisions
that can be handled in a trade. The divisibility characteristic of Financial Assets enables all players, small
or big, to participate in the market.

3.      Convertibility

Financial Assets are convertible into any other type of asset. This characteristic of convertibility gives
flexibility to financial instruments. Financial Instruments need not necessary be converted into another
form of Financial Asset; they can also be converted into Physical/Tangible and Intangible Assets.

4.      Reversibility

This implies that a financial instrument can be exchanged for any other asset and logically, the so formed
asset may be transferred back into the original financial instrument.

5.      Liquidity /Marketability/

Liquidity implies that the present need for other forms of asset prevails over holding the financial
instrument. The financial asset can be exchanged for currency with another market participant who does
not have immediate cash need, but expects future benefits.

6.      Cash Flow

The holding of the financial instrument results in a stream of cash flows that are the benefits accruing to
the holder of the financial instrument. However, a financial instrument by itself does not create a cash
flow.

7. Information Availability
In many cases, information concerning financial assets is more readily available than for real assets
1.3 Financial Markets

A financial market is a market where financial instruments are exchanged. The more popular term used
for the exchanging of financial instruments is that they are “traded.” They are markets where people buy
and sell financial instruments like stocks, bonds and future contracts.

Financial markets provide the following three major economic functions:

 Price discovery
 Liquidity
 Reduced transaction costs
Price discovery means that the interactions of buyers and sellers in a financial market determine the price
of the traded asset. Equivalently, they determine the required return that participants in a financial
market demand in order to buy a financial instrument. Because the motivation for those seeking funds
depends on the required return that investors demand, it is the functions of financial markets that signals
how the funds available from those who want to lend or invest funds will be allocated among those
needing funds and raise those funds by issuing financial instruments.

Second, financial markets provide a forum for investors to sell a financial instrument and is said to offer
investors “liquidity”. This is an appealing to sell a financial instrument. Without liquidity, an investor
would be compelled to hold onto a financial instrument until either condition arise that allow for the
disposal of the financial instrument or the issuer is contractually obligated to pay it off. For a debt
instrument, that is when it matures, whereas for an equity instrument that is until the company is either
voluntarily or involuntarily liquidated. All financial markets provide some form of liquidity. However,
the degree of liquidity is one of the factors that characterize different financial markets.

The third economic function of a financial market is that it reduces the cost of transacting when parties
want to trade a financial instrument. In general, one can classify the costs associated with transacting into
two types: search costs and information costs. Search costs in turn fall into two categories: explicit costs
and implicit costs. Explicit costs include expenses that may be needed to advertise one’s intention to sell
or purchase a financial instrument; implicit costs include the value of time spent in locating counterparty
to the transaction. The presence of some form of organized financial market reduces search costs.
Information costs are costs associated with assessing a financial instrument’s investment attribute. In a
price efficient market, prices reflect the aggregate information collected by all market participants.

1.3.1Financial markets structure

Financial instruments
There is a great variety of financial instrument in the financial marketplace. The use of
these instruments by major market participants depends upon their offered risk and return
characteristics, as well as availability in retail or wholesale markets. The general view on
the financial instrument categories is provided in Table 1.
Table 1.1. Financial Instrument Categories

Category Risk determinants Expected returns Main participants

Non tradable In wholesale money In wholesale In wholesale money
and non- markets: transaction money markets: markets: banks
transferable volumes low

In retail markets: low In credit markets: In retail markets: banks

transparency, lack of low and non-bank firms
standardization, low and households
creditworthiness
In foreign exchange In foreign In foreign exchange
markets: high volatility, exchange markets: financial
change of currency markets: high institutions, companies
Securities Market volatility, Comparably high Banks and non-bank
individual risks and firms, individuals
failures
Derivatives Market volatility, leverage Very high Banks and non-bank
firms, individuals

A financial instrument can be classified by the type of claims that the investor has on the issuer. A
financial instrument in which the issuer agrees to pay the investor interest plus repay the amount
borrowed is a debt instrument. A debt instrument also referred to as an instrument of indebtedness, can
be in the form of a note, bond, or loan. The interest payments that must be made by the issuer are fixed
contractually. For example, in the case of a debt instrument that is required to make payments in Euros,
the amount can be a fixed Euro amount or it can vary depending upon some benchmark. The investor in
a debt instrument can realize no more than the contractual amount. For this reason, debt instruments are
often called fixed income instruments. Fixed income instruments forma a wide and diversified fixed
income market. The key characteristics of it are provided in Table 2.

Table 1.2.Fixed-income market

Market Features Issuers

Long Bonds Long-term obligations to make a Governments,
term series of fixed payments firms
Convertibles Bonds that can be swapped for Firms
equity at pre-specified conditions
Asset-backed Securitised “receivables” Financial
securities presenting future streams of institutions, firms
payments
Preferred stock, Debt and equity hybrids Firms
subordinated debt
 Medium Notes Medium-term obligations Governments
term
Floating-rate notes Medium-term instruments with Firms
interest rates based on LIBOR or
another index
Short Bills Short-term obligations Governments
term
Commercial paper Short-term debt instruments Firms
Certificates of Short-term debt instruments Banks
deposit

In contrast to a debt obligation, an equity instrument specifies that the issuer pays the
investor an amount based on earnings, if any, after the obligations that the issuer is
required to make to investors of the firm’s debt instruments have been paid.

Common stock is an example of equity instruments. Some financial instruments due to

their characteristics can be viewed as a mix of debt and equity.

Preferred stock is a financial instrument, which has the attribute of a debt because
typically the investor is only entitled to receive a fixed contractual amount. However, it is
similar to an equity instrument because the payment is only made after payments to the
investors in the firm’s debt instruments are satisfied.

Another “combination” instrument is a convertible bond, which allows the investor to

convert debt into equity under certain circumstances. Because preferred stockholders
typically are entitled to a fixed contractual amount, preferred stock is referred to as a fixed
income instrument.

Hence, fixed income instruments include debt instruments and preferred stock. The
features of debt and equity instruments are contrasted in Table 3

The classification of debt and equity is especially important for two legal reasons. First, in
the case of a bankruptcy of the issuer, investor in debt instruments has a priority on the
 Unit One

claim on the issuer’s assets over equity investors. Second, the tax treatment of the payments by
the issuer can differ depending on the type of financial instrument class.

Table1. 3. Debt Versus Equity

Debt Equity

Characteristic Borrower-lender relation, Ownership, no time limit

fixed maturities

Advantages:

 for the firm Predictability, independence Flexibility, low cost of finance,

from shareholders’ influence reputation

 for the investor Low risk High expected return

Disadvantages:

 for the firm Debt servicing obligation Shareholder dependence, short-

sightedness, market volatility
influencing management
decisions

 for the investor Low returns High risk

Classification of financial markets

There different ways to classify financial markets. They are classified according to
the financial instruments they are trading, features of services they provide,
trading procedures, key market participants, as well as the origin of the markets.

The generalized financial market classification is given in

Table 4.

11
 Unit One

Table 4. Financial market classification

Criterion Features Examples

Products Tradability, transferability, Equity, debt instruments, derivatives

ownership, maturity,
denomination, substance

Services Technical, advisory, IT support, research and analysis,

information and knowledge- custody
based, administrative

Ways of Physical, electronic, virtual Over the counter, exchange, internet

trading

Participants Professionals, non- Banks, central banks, non-bank financial

professionals, institutions, companies, institutional investors,
officials business firms, households

Origin Domestic, cross-border, National markets, regionally integrated

regional, international markets, Euromarkets, domestic/foreign
currency markets, onshore/offshore
markets

From the perspective of country origin, its financial market can be broken down
into an internal market and an external market.

The internal market, also called the national market, consists of two parts: the domestic
market and the foreign market. The domestic market is where issuers domiciled in the country
issue securities and where those securities are subsequently traded.

The foreign market is where securities are sold and traded outside the country of issuers.

External market is the market where securities with the following two distinguishing
features are trading: 1) at issuance they are offered simultaneously to investors in a number
of countries; and 2) they are issued outside the jurisdiction of any single country. The

12
 Unit One

external market is also referred to as the international market, offshore market, and the
Euromarket (despite the fact that this market is not limited to Europe).

Money market is the sector of the financial market that includes financial
instruments that have a maturity or redemption date that is one year or less at the
time of issuance. These are mainly wholesale markets.

The capital market is the sector of the financial market where long-term financial
instruments issued by corporations and governments trade. Here “long-term” refers to a
financial instrument with an original maturity greater than one year and perpetual securities
(those with no maturity). There are two types of capital market securities: those that represent
shares of ownership interest, also called equity, issued by corporations, and those that
represent indebtedness, or debt issued by corporations and by the state and local
governments.

Financial markets can be classified in terms of cash market and derivative markets.

The cash market, also referred to as the spot market, is the market for the
immediate purchase and sale of a financial instrument.

In contrast, some financial instruments are contracts that specify that the contract holder has
either the obligation or the choice to buy or sell another something at or by some future date.
The “something” that is the subject of the contract is called the underlying (asset). The
underlying asset is a stock, a bond, a financial index, an interest rate, a currency, or a
commodity. Because the price of such contracts derives their value from the value of the
underlying assets, these contracts are called derivative instruments and the market where
they are traded is called the derivatives market.

When a financial instrument is first issued, it is sold in the primary market. A secondary
market is such in which financial instruments are resold among investors. No new capital is
raised by the issuer of the security. Trading takes place among investors. Secondary markets are
also classified in terms of organized stock exchanges and over-the- counter (OTC) markets.

Stock exchanges are central trading locations where financial instruments are
traded. In contrast, an OTC market is generally where unlisted financial
instruments are traded.
13
 Unit One

1.4 Lending and borrowing in the financial system

1.4.1 Financial Markets Funds Transferees

Lender-Savers Borrower-Spenders

1. Business firms Households

2. Government Business firms

3. Households Government

4. Foreigners Foreigners

Methods of funds transfer

 . Direct financing

 Indirect financing

1. . Direct financing

Borrowers borrow directly from lenders in financial markets by selling financial instruments
which are claims on the borrower’s future income or assets. Securities are assets for the person
who buys them. They are liabilities for the individual or firm that issues them

2. Indirect financing

Borrowers borrow indirectly from lenders via financial intermediaries (established to source both
loanable funds and loan opportunities) by issuing financial instruments which are claims on the
borrower’s future income or assets

14