What are the Components of Financial System?

The financial system is all about taking money from someone who has ample of it and making it to
reach those who have the best opportunities to utilise it. This way the economic resources are allocated
most efficiently and best returns are ensured.  Economic transactions are done by various organisations
like banks, pension funds, organised exchanges and insurance companies and many more. They are the
financial institutions who use various financial instruments such as bonds, stocks, interests derived on
deposits, credit to the borrowers etc. 
Objectives of the financial system 
The main objectives of this system are:
 To create a structured payment system
 To give money the time value as it deserves
 To reduce risks and compensate for the same through offering products and services
 To enable the most efficient economic resource allocation 
 To maintain market stability in the economic sector
Components of the system
1. Financial Institutions
Here is where the borrowers meet the investors. The latter’s investment is utilised in various sectors via
financial instruments and investing in the financial market. There are myriad service providers in this
same field also who get involved in the process. They can be of any type, Regulatory, Intermediaries,
non-intermediaries and Others. There are organisations which seek the assistance of these service
providers every now and then and strategic ideas regarding the diversification or restructuring of the
unit are provided. In this way, financial assets like loans, securities and other deposits are taken care of
along with raising funds from the market. All sorts of services are thus reached to the service-users. 
2. Financial Markets
In financial markets, the exchange of financial assets is involved in terms of both the creation and
transfer of the same. The difference here with a real transaction is that there is no direct money
involved in the exchange process and instead of products or services, deposits, loans and other such
financial assets are used for the transaction process. There are financial instruments involved in this.
Here a claim of payment of money in the future is made and interest or dividend is paid on a periodic
basis. The financial market again is composed of four units. 
a. Money Market
This refers to a wholesale market of debts involving financial instruments that are low-risk, short-term
and highly-liquid. One can get funds for a day’s span up to a year’s. Banks, the government and other
financial institutions regulate such a market. 
b. Capital Market
This is for investments of long-term nature, such as more than a year. 
c. Foreign Exchange Market
Exchange of currencies in a multicurrency facet is what foreign exchange markets are for. There is a
particular exchange rate fixed depending on which the funds are transferred within the market. This
particular market is the most developed one in the world. 
d. Credit Market 
In this market loans of medium or long-term tenure are given to the individuals or corporate companies
by financial institutions, banks, Non-Bank Financial Institutions or NBFCs etc. 
3. Financial Instrument 
All securities and financial assets fall under the broad category of financial instruments. Various
investors and credit seekers have the demand for various types of loans and deposits. Thus the
securities are of various types too. A principal is settled which will be repaid by regular dividends or
interests. Bonds, debentures and equity shares are a few financial instruments. 
4. Financial Services
These are derived from the Liability Management and Asset Management companies. These help in
both acquiring and investing the money appropriately. Their assistance is sought for determining the
financing combination. From borrowing to selling, purchasing to the lending of securities, making
payments to regulating risk exposures- all are looked after by these service providers. The clients are
myriad starting from mutual fund houses, acceptance houses, leasing companies to merchant bankers
and portfolio managers. The services offered here are credit rating, book building, merchant banking,
capital financing, depository services and mutual funds. 
5. Money 
This may be mentioned at the last but it is undoubtedly one of the most important components of the
financial system. Money refers to anything that is used to pay for the products bought or services used
and accepted by the seller too. Money acts as an exchange medium for repayment and a complete
transaction process. Money holds the value of the product or service. The exchange process is eased out
when money is utilised. 
Thus, the financial system is the common meeting place of the borrowers and lenders from where both
can reap mutual benefits. Situations where capital crunch is higher (as in India), the proper action of
financial institute can result in capital accumulation. At the end, the country finds economic
development which is much desired.
Role of financial system in economic development of a country
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Relationship between financial system and economic development
The development of any country depends on the economic growth the country achieves over a period of
time. Economic growth deals about investment and production and also the extent of Gross Domestic
Product in a country. Only when this grows, the people will experience growth in the form of improved
standard of living, namely economic development.
Role of financial system in economic development of a country

The following are the roles of financial system in the economic development of a country.
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.
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.
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.
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.
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 do 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 hire purchase and installment system, both in the domestic and
foreign trade. As a result of all these, the growth of the country is speeded up.
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.
Venture Capital
There are various reasons for lack of growth of venture capital companies in India. 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.
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.
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.
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.
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.
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.
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.
Financial system helps in Uniform interest rates
The financial system is capable of bringing an uniform interest rate throughout the country by which
there will be balanced movement of funds between centres which will ensure availability of capital for
all kinds of industries.
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

What is Capital Market?

Capital market refers to facilities and institutional arrangements through which Medium and long-term
funds (for a period of minimum 365 days and above), both debt and equity are raised and invested. It
provides all with a series of channels through which savings of the community are made available for
industrial and commercial enterprises and for the public in general. The capital market consists of
development banks, commercial banks and stock exchanges.  
Instruments of capital market
Savings of the investors are generally raised through a range of complex financial products generally
called capital market instruments such as shares, Debentures, bonds or any other marketable securities
of a like nature issued by any company etc. Following are the various types of capital market
instruments available in the Indian Capital Market:
Shares
The ownership capital of a company is divided into a number of indivisible units of a fixed amount.
These units are known as shares As per Section 43 of the Companies A 2013, the share capital of a
company limited by shares shall be of two kinds, namely Equity share capital and Preference share
capital. Equity Shares
 The purpose of equity instruments issued by corporations is to raise funds for the firms.
 It is equity ownership that allows the holders of this stock to enjoy voting rights on corporate
matters.
 However, in case the company suffers heavy losses and ends up bankrupt, the holders of the
common stock are the last ones to get their money back after creditors, bondholders, and holders
of preferred stock.
Debt instruments 
A debt instrument is used by either companies or governments to generate funds for capital-intensive
projects that can be obtained either through the primary or secondary market. The relationship in this
form of instrument ownership is that of a borrower – creditor and thus, does not necessarily imply
ownership in the business of the borrower. The contract is for a specific duration and interest is paid at
specified periods. Types of Debt Instruments are of different types like Bonds, Debentures and
Government Securities
Derivative instruments 
A derivative instrument is whose value is derived from the value of one or more underlying assets
which can be commodities, precious metals, currency, bonds, stocks, stock indices, etc. Forwards,
Futures, Options and Swaps are four most common examples of derivative instruments. The purpose of
these securities is to give producers and manufacturers the possibility to hedge risks. By using
derivatives both parties agree on a sale at a specified price at a later date. Derivatives market can be
divided into two as follows:
1. Exchange-traded derivatives
2. Over-the-counter derivatives.
What is the Capital Market Services Provided by Banks?
3. The capital market services provided by banks are as follows:
Lead-Manager to the Public Issue
The bank will take the responsibility of completing all the legal and regulatory formalities,
including the drafting of the Prospectus for the public issue and also will manage all the affairs
related to the public issue.
 Advisor to the Issue
On many occasions, the companies retain the banks for advising on a particular service required by
them for public issues. The banks perform this job against a number of fees for the provided services.
 Banker to the Issue
To distribute share application forms to potential investors, the banks function as bankers to the public
issue to the potential investors in all parts of the country for the purpose of capital market services. The
share application forms are duly filled and signed by them together with the application fees in the
banks' branches acting as banker to the issue.
 Dividend and Interest Paying Bank
Banks having their branches all over are the essential vehicle for payment of dividends or interest by
the corporation. The companies that have borrowed funds from the public by way of accepting the fixed
deposits and issuing debentures, bonds, etc., on which they are asked to pay interest within a specified
time frame. The company earning profits pays dividends to its shareholders.
 Underwriting
The banks often underwrite the whole or part of the public issue by a company. Through underwriting,
the bank gives assurance to the company to subscribe to the issue if the investors do not fully accept the
issue. In the full absence or the investors' required subscription, the underwriting bank has to put its
own application to purchase the shares before the closing of the issue
Regulation of Securities Markets
The Division of Market Regulation oversees the operations of the nation’s securities markets and
market participants. In 2001, the SEC supervised approximately 7,900 registered broker-dealers with
over 87,765 branch offices and over 683,240 registered representatives. Broker-dealers filing FOCUS
reports with the Commission had approximately $3 trillion in total assets and $208 billion in total
capital for fiscal year 2001. In addition, the average daily trading volume reached 1.2 billion shares on
the New York Stock Exchange and over 1.9 billion shares on the Nasdaq Stock Market as of September
30, 2001
What We Did
• Adopted two rules that require improved disclosure of order execution and routing practices by
market centers and broker-dealers.
• Issued a concept release to solicit comments on the effects of subpenny trading on the markets and
investors.
• Engaged in rulemaking and provided guidance to implement the provisions of the Commodity Futures
Modernization Act of 2000 (CFMA) that allow trading of single stock futures.
• Amended a Commission rule to require quotations for exchange-listed options to be firm
SEBI’s Role
While trading in the Indian stock market, investors and traders have to execute trades while abiding by
rules. This is to promote fairness. SEBI’s role is to carry out functions that meet with the tenets of SEBI
regulations and these functions include the following: 
 SEBI regulates Capital Markets through certain measures it takes.
 Protects the interests of traders and investors, thereby, promoting fairness in the stock exchange.
 SEBI regulates how the security markets and stock exchanges function.
 SEBI regulates how transfer agents, stock brokers and merchant bankers, etc, function. 
 SEBI handles the registration activity of new brokers, financial advisors, etc. 
 SEBI encourages the formation of Self-regulatory Organizations.
 SEBI promotes investor learning opportunities.
 SEBI makes rules to prevent malpractice.
 SEBI manages and controls a ‘complaints’ division. 
What is the Financial Sector?
 The financial sector constitutes the commercial banks, non-banking financial companies,
investment funds, money market, insurance and pension companies, real estate etc.
 It forms the core of an economy which facilitates the mobilization and distribution of financial
resources.
 It is engaged in providing financial services to the customers of the commercial and retail
segments.
Need
Need for Financial Sector Reforms
 After independence India inherited a colonial legacy that was full of various social and economic
deprivations.
 The planned economic development strategy adopted based on the Mahalanobis model had its
limitations that started showing in the 1980s.
 In order to achieve various economic goals, the government resorted to increased borrowings at
concessional rates which lead to weak and underdeveloped financial markets in India.
 The nationalization of banks increased government control and decreased the role of market
forces in the financial sector.
  Increased bureaucratic control, issues of red-tapism increased the non-performing assets.
 Turbulent international events such as the war in the Middle East and the fall of the USSR
increased the pressure on the Foreign Exchange Reserves of India.
Narasimham Committee report (1991)
Narasimham Committee report (1991)
 It was established to give reforms pertaining to the financial sector of India including the capital
market and banking sector.
 Some of its major recommendations have been mentioned below:
o It recommended reducing the cash reserve ratio (CRR) to 10% and the statutory
liquidity ratio (SLR) to 25% over the period of time.
o It suggested fixing at least 10% of the credit for priority sector lending to marginal
farmers, small businesses, cottage industries, etc.
o In order to provide required independence to the banks for setting the interest rates
themselves for the customers, it recommended de-regulating the interest rates.
Financial Sector Reforms in India
Financial Sector Reforms in India
Reforms in the Banking Sector
 Reduction in CRR and SLR has given banks more financial resources for lending to the
agriculture, industry and other sectors of the economy.
 The system of administered interest rate structure has been done away with and RBI no longer
decides interest rates on deposits paid by the banks.
 Allowing domestic and international private sector banks to open branches in India, for
example, HDFC Bank, ICICI Bank, Bank of America, Citibank, American Express, etc.
 Issues pertaining to non-performing assets were resolved through Lok adalats, civil courts,
Tribunals, The Securitisation And Reconstruction of Financial Assets and the Enforcement of
Security Interest (SARFAESI) Act.
 The system of selective credit control that had increased the dominance of RBI was removed so
that banks can provide greater freedom in giving credit to their customers.
Reforms in the Debt Market
 The 1997 policy of the government that included automatic monetization of the fiscal
deficit was removed resulting in the government borrowing money from the market through the
auction of government securities.
 Borrowing by the government occurs at market-determined interest rates which have made the
government cautious about its fiscal deficits.
 Introduction of treasury bills by the government for 91 days for ensuring liquidity and meeting
short-term financial needs and for benchmarking.
 To ensure transparency the government introduced a system of delivery versus payment
settlement.
Reforms in the Foreign Exchange Market
 Market-based exchange rates and the current account convertibility was adopted in 1993.
  The government permitted the commercial banks to undertake operations in foreign
exchange.
 Participation of newer players allowed in rupee foreign currency swap market to undertake
currency swap transactions subject to certain limitations.
 Replacement of foreign exchange regulation act (FERA), 1973 was replaced by the foreign
exchange management act (FEMA), 1999 for providing greater freedom to the exchange
markets.
 Trading in exchange-traded derivatives contracts was permitted for foreign institutional
investors and non-resident Indians subject to certain regulations and limitations.
Impact of Various Reforms
Impact of Various Reforms in the Financial Sector
 It increased the resilience, stability and growth rate of the Indian economy from around 3.5 %
to more than 6% per annum.
 A resilient banking system helped the country deal with the Asian economic crisis of 1977-98
and the Global subprime crisis.
 The emergence of private sector banks and foreign banks increased competition in the banking
sector which has improved its efficiency and capability.
 Better performance by stock exchanges of the country and adoption of international best
practices.
 Better budget management, fiscal deficit, and public debt condition have improved after the
financial sector reforms.
Conclusion
Conclusion
The financial sector forms the backbone of an economy and includes the sore sectors such as banking,
foreign exchange, insurance. In order to break the colonial hegemony of policies, various reforms in the
financial sector were carried out that enabled the strengthening of the banking sector, better
management of foreign reserves, etc enabled in economic growth and development