AN OVERVIEW OF FINANCIAL SYSTEMS

The financial system of a country consists of money, financial instruments, financial markets,
financial institutions, and the central bank. The financial systems of the most of the developing
countries are characterised by the coexistence of formal and informal financial sectors. This is
commonly referred to as ‘financial dualism’. The formal financial sectors are organized,
institutional and regulated systems while the informal financial sectors are unorganized, non-
institutional and non-regulated systems primarily operating in the rural areas. The informal
sector survives primarily because of the inaccessibility of certain sections of the population to the
formal financial sectors. In India the formal financial system comes under the purview of
Ministry of Finance, RBI and SEBI (Securities and Exchange Board of India) along with other
regulatory bodies. This chapter will cover functions and components of formal financial systems
with a focus on India financial system.

Functions of financial systems

A developed and efficient financial system is highly beneficial for economic growth and
development as it performs certain very important functions. First of all, it acts as a link between
the savers and the investors by mobilizing and allocating resources from the savers to the
investors. This in turn reduces transaction costs. Second, it not only allocates funds to projects
for investments, but also entails monitoring of the project performance. Poor corporate
performance results in bankruptcies and takeovers. Third, efficiency of a financial system makes
payment and settlement mechanism also highly efficient which are backbone of a modern
economic system. Fourth, it facilitates the process of optimum risk allocation. It limits, pools and
trades in risks involved in mobilizing savings and allocating credits. Risks are reduced by laying
rules governing the operations, holding diversified portfolios and screening of borrowers. Fifth,
it performs a very important task of disseminating price related information which assists the
investors in decision making and the managements of corporations to evaluate and revise their
strategies. Overall it reduces information asymmetry. Sixth, it also offers portfolio adjustment
facility which includes services of providing a quick, cheap and reliable way of buying and
selling a wide variety of financial assets. And, seventh, a well developed financial system helps
in financial deepening and broadening. Financial deepening refers to the increase in liquid
financial assets as a percentage of GDP. Financial broadening is measured in terms increase in
the number and variety of participants and instruments.

Financial instruments
Among the components, money has already been discussed. Now, financial (market) instruments
are written legal obligations of one party to transfer something of value, usually money, to
another party at some future date, under certain conditions. Stocks, loans, insurance all are
examples of financial instruments. However, some of the financial instruments are marketable
and some are not. The marketable financial instruments are called securities. They perform three
functions: i) a means of payment, ii) store of value and iii) transfer of risk. As a means of
payments securities are not yet very commonly accepted. Nevertheless, sometimes companies
give their stocks to willing employees as a bonus payment or payment for work. As a store of
value, securities perform better than money since they tend to have better yield. And, the third
one, i.e. transfer of risk, is a specific task only securities perform and not money. For instance,
consider insurance contracts where the risk is transferred from individuals to insurance
companies. A house is insured because any damage to the property would imply huge loss.
Through insurance whole or a part of the risk associated with any accidental damage to the
property is transferred to the insurance company. Because insurance companies make similar
guarantees to a large group of people, they have the capacity to shoulder the risk.

Financial instruments differ from each other in terms of their investment characteristics. Some of
the important investment characteristics are i) liquidity, which depends on marketability and
transferability, ii) transaction costs, iii) risk of default, iv) maturity period, v) tax status vi)
volatility of prices and vii) the rate of return. However, the instruments can be categorized in
terms of their maturity period and hence the markets they are traded in, i.e. money market
instruments and capital market instruments. First, the money market instruments are discussed.

Treasury Bills – treasury bills are issued by RBI to finance short term financial requirements of
the Government of India (GoI). They are the most important segment of the money market. The
advantages with treasury bills are i) highly liquid, ii) negotiable securities, iii) offer risk free
investment (almost no possibility of default) iv) provide assure reasonable yield, and v) eligible
for inclusion in the securities for SLR. Any banks, other financial institutions, corporate bodies,
mutual funds, foreign institutional investors, state governments, provident funds, primary
dealers, and foreign banks are eligible to bid and purchase treasury bills. At present, the GoI
issues three types of treasury bills through auctions, namely, 91-day, 182-day and 364-day.
There are no treasury bills issued by State Governments. Treasury bills are available for a
minimum amount of Rs.25,000 and in multiples of Rs. 25,000. Treasury bills are issued at a
discount and are redeemed at par. While 91-day T-bills are auctioned every week on Friday, 182-
day and 364-day T-bills are auctioned every alternate week on Wednesdays. There are two types
of auctions. In multiple price-based or French auctions where all bids equal to or above the cut-
off price are accepted which exhausts all the issues. However, the bidder has to obtain the
Treasury bill at the price quoted by him. This is method is followed in the case of 364-day and
182-day treasury bills. In uniform price based or Dutch auctions all the bids equal to or above
the cut-off price are accepted and the bidders pay a uniform price as decided by the RBI, not the
prices quoted by them. This method is applied for 91 days Treasury bills. Further, the bids
submitted can be classified as competitive and non-competitive bids. While competitive bids
involve price competition among the participants for T-bills allotment, the state governments,
non-government provident funds and Nepal Rashtra Bank are allowed to submit non-competitive
bids in the case of 91 days Treasury bill. For 364 days Treasury bills only state governments can
participate as non-competitive bidders. All the non-competitive bids are accepted at the weighted
average price of the competitive bids.
Cash management bills – CMBs have the generic character of T-bills but are issued for
maturities less than 91 days. Further, the non-competitive bidding scheme has not been extended
to the CMBs.

Call or Notice Money Market – it is a key segment of the Indian money market as the day-to-
day surplus funds are traded here, mostly by banks. It is a market for very short term funds
repayable on demand with a maturity period varying between one day to 14 days. When money
is lent or borrowed for a day, it is known as call (overnight) money. Intervening holidays or
Sundays are not counted. When money is borrowed or lent for more than a day up to 14 days, it
is called notice money. These are unsecured, highly risky and volatile transactions. Call money is
required primarily for maintaining CRR by the banks. The participants in the call/notice money
market are scheduled commercial banks, cooperative banks and primary dealers. While there are
borrowing restrictions on all of them, there is no restriction on the lending limit of cooperative
banks. Other non-bank institutions are not allowed in the call/notice money market.

Aside: a primary dealer is a firm that is allowed to purchase government securities directly from
the government for reselling in the securities market. Below a list of primary dealers in India is
given as reported by RBI on June 13, 2014.

Standalone PD Bank PD
ICICI Securities Primary Dealership Ltd. Bank of America
Morgan Stanley India Primary Dealer Pvt. Ltd. Bank of Baroda
Nomura Fixed Income Securities Pvt. Ltd. Canara Bank
PNB Gilts Ltd. Citibank N.A.
SBI DFHI Ltd. Corporation Bank
STCI Primary Dealer Ltd HDFC Bank Ltd.
Goldman Sachs (India) Capital Markets Pvt. Ltd. Hongkong and Shanghai Banking Corpn. Ltd.
J P Morgan Chase Bank N.A
Kotak Mahindra Bank Ltd.
Standard Chartered Bank
Axis Bank Ltd.
IDBI Bank Ltd.
Deutsche Bank AG

Collateralised borrowing and lending obligations (CBLO) – The Clearing Corporation of India
Ltd launched a new product – CBLO on Jan 20, 2003 to provide liquidity to entities hit by
restrictions on access to the call money market. CBLO is a discounted instrument available on
electronic book entry form for the maturity period between 1 to 19 days. The eligible securities
are central government securities including T-bills.

Commercial Papers - Commercial papers are unsecured negotiable and transferable promissory
notes with a fixed maturity period. They are issued by creditworthy companies and financial
institutions to meet their working capital requirement. They are issued at a discounted rate of
their face value. Scheduled commercial banks are the major investors in commercial papers.
Banks prefer commercial papers over loans since CPs are short term instruments and offer
attractive profit condition. Banks often borrow from call money market to fund investments in
CPs.

Commercial bills - a commercial bill is a short term negotiable, and self-liquidating instrument
with low risk. Bills of exchange or trade bills are negotiable instruments drawn by the seller on
the buyer for the value of the goods delivered. When trade bills are accepted by commercial
banks they are called commercial bills. The maturity period of the bills vary from 30 to 90 days
depending on the credit extended by the industry. It is of two types: demand bill and usance bill.
A demand bill is payable on demand; i.e. immediately on presentation to the drawee. A usance
bill is payable at a future date.

Certificates of Deposit – a certificate of deposit is a debt instrument sold by a bank to depositors

that pays annual interest and at maturity pays back the original purchase price. They are
unsecured short term instruments issued by commercial banks and developed financial
institutions. CDs are time deposits of specific maturity similar to fixed deposits. The biggest
difference between the two is that CDs are negotiable. CDs are issued by banks during period of
tight liquidity at relatively high interest rates. They represent high cost liability. Banks resort to
this source when deposit rate is sluggish but credit rate is high. Though negotiable, the markets
for these deposits have remained dormant since they are high yielding instruments and investors
prefer to hold them. Minimum amount of a CD should be 1 lakh and maturity period not less
than 7 days.

Capital market instruments are securities with maturities greater than one year. The principal
capital market instruments are discussed below.

Stocks - Stocks are equity claims on the net income and assets of a corporation. The total value
of stocks traded in India stood at more than US$ 622 billion in 2012 (World Bank).

Mortgages and Mortgage-backed Securities - Mortgages are loans to households or firms to

purchase housing, land, or other real structures, where the structure or land itself serves as
collateral for the loans. Mortgages are provided by savings and loan associations, mutual savings
banks, commercial banks and insurance companies. In recent years a growing amount of the
funds for mortgages have been provided by mortgage-backed securities, a bond-like instrument
backed by a bundle of individual mortgages, whose interest and principal payments are
collectively paid to the holder of the security.

Corporate Bonds – these are long term bonds issues by corporations with very strong credit
ratings. A typical corporate bond sends the holder an interest payment twice a year and pays off
the face value when the bond matures. Some corporate bonds called convertible bonds have the
additional feature of allowing the holder to convert them into a specified number of shares of
stock at any time up to the maturity date. The principal buyers of corporate bonds are life
insurance companies, pension funds, and households.

Government Securities - A Government security is a tradable instrument issued by the Central

Government or the State Governments. It acknowledges the Government’s debt obligation. Such
long term securities are usually called Government bonds or dated securities with original
maturity up to 30 years. In India, the Central Government issues bonds or dated securities and
those issued by the State Governments are called the State Development Loans (SDLs).
Government securities carry practically no risk of default and, hence, are called risk-free gilt-
edged instruments. Government of India also issues savings instruments (Savings Bonds,
National Saving Certificates (NSCs), etc.) or special securities (oil bonds, Food Corporation of
India bonds, fertiliser bonds, power bonds, etc.).

State and Local Government Bonds – also called municipal bonds are long-term bonds issued
by state and local governments to finance expenditure on schools, roads and other large
programmes. In the US interest income from these bonds are exempted from income tax and
state taxes in the issuing state. Commercial banks are the biggest buyers of these securities.

Financial institutions
Financial institutions are business organizations that mobilise and act as depositories of savings
and as purveyors of credit or finance. They also provide various financial services like providing
loans and advances, acquisition of shares/stocks/bonds/debentures/securities issued by
Government or local authority or other marketable securities, leasing, hire-purchase, and
insurance business. Financial institutions can be classified as i) banking and non-banking
institutions and ii) intermediaries and non-intermediaries. Though the banking and non-banking
financial institutions have a number of things common, they primarily differ in terms of the
latter’s inability to accept demand deposits; e.g. all insurance companies like LIC, GIC, Reliance
Capital, Indiabulls, NABARD, SIDBI (Small Industries Development Bank of India) and
primary dealers.

On the other hand, intermediaries intermediate between savers and investors by lending money
as well as mobilising savings. Non-intermediaries do the loan business but their resources are not
directly obtained from the savers. All banking institutions are intermediaries. Many non-banking
institutions also act intermediaries and they are known as non-bank financial intermediaries
(NBFIs). The non-intermediary institutions like IFCI (Industrial Finance Corporation of India)
and NABARD (National Bank for Agriculture and Rural Development) have come into
existence because of government’s effort to provide assistance for specific purposes, sectors and
regions where the credit needs of certain borrower might not be otherwise adequately met by
private institutions. A categorization of financial intermediaries is given below.

Depository Institutions – these are financial intermediaries that accept deposits from individual
and institutions and make loans. Since deposits are important component of money supply, these
institutions also form a significant part of financial systems. They include commercial banks and
thrift institutions like savings and loan associations, mutual savings banks and credit unions.
Commercial banks raise funds primarily by issuing chequeable deposits, savings deposits and
time deposits. They then use these funds to make commercial, consumer and mortgage loans,
and to buy central and state government securities. Thrift institutions primarily are non-profit
banks where owners are the customers. So, they get their profits through yearly payback or
dividends. For instance credit unions are typically very small cooperative lending institutions
organized around a particular group, like union members, and employees of a particular firm.
They acquire funds from deposits called shares and make consumer loans.

Contractual Savings Institutions - Contractual savings institutions, such as insurance companies

and pension funds, are financial intermediaries that acquire funds at periodic intervals on a
contractual basis. Because they can predict with reasonable accuracy how much they will have to
pay out in benefits in the coming years, they do not have to worry as much as depository
institutions about losing funds quickly. As a result, the liquidity of assets is not as important a
consideration for them as it is for depository institutions, and they tend to invest their funds
primarily in long-term securities such as corporate bonds, stocks, and mortgages. Life insurance
companies insure people against financial hazards following a death and sell annuities (annual
income payments upon retirement). They acquire funds from the premiums that people pay to
keep their policies in force and use them mainly to buy corporate bonds and mortgages. They
also purchase stocks, but are restricted in the amount that they can hold. Fire and casualty
insurance companies insure their policyholders against loss from theft, fire, and accidents. They
are very much like life insurance companies, receiving funds through premiums for their
policies, but they have a greater possibility of loss of funds if major disasters occur. For this
reason, they use their funds to buy more liquid assets than life insurance companies do. Pension
funds and government retirement funds provide retirement income in the form of annuities to
employees who are covered by a pension plan. Funds are acquired by contributions from
employers and from employees, who either have a contribution automatically deducted from
their pay-checks or contribute voluntarily. In India we have we major categories of pension
plans: i) deferred annuity plans and ii) immediate annuity plans. For the former, the contributors
keep paying premiums for certain numbers of years, called accumulation phase. And, after
retirement one starts getting pension income, known as the distribution phase. Examples of this
type of plans are LIC Jeevan Tarang, LIC Jeevan Nidhi, NPS, Bajaj Allianz Swarna Raksha etc.
In the later category annuities are paid immediately after the payment of premium. This is a less
popular scheme in India. Examples include LIC Jeevan AKshay, ICICI Pru Immediate Annuity,
HDFC Immediate Annuity etc. The largest asset holdings of pension funds are corporate bonds
and stocks.

Investment Intermediaries - This category of financial intermediaries includes finance

companies, mutual funds, money market mutual funds and investment banks. Finance companies
raise funds by selling commercial papers (a short-term debt instrument) and by issuing stocks
and bonds. They lend these funds to consumers for purchasing items as furniture, automobiles,
and home improvements, and to small businesses. Some finance companies are organized by a
parent corporation to help sell its product, e.g. Maruti Finance. Mutual funds acquire funds by
selling shares to many individuals and use the proceeds to purchase diversified portfolios of
stocks and bonds. Mutual funds allow shareholders to pool their resources so that they can take
advantage of lower transaction costs when buying large blocks of stocks or bonds. In addition,
mutual funds allow shareholders to hold more diversified portfolios than they otherwise would.
Shareholders can sell (redeem) shares at any time, but the value of these shares will be
determined by the value of the mutual fund's holdings of securities. Money market mutual funds
have the characteristics of a mutual fund but also function to some extent as a depository
institution because they offer deposit-type accounts. Like most mutual funds, they sell shares to
acquire funds that are then used to buy money market instruments that are both safe and very
liquid. The interest on these assets is paid out to the shareholders. A key feature of these funds is
that shareholders can write cheques against the value of their shareholdings. In effect, shares in a
money market mutual fund function like checking account deposits that pay interest. Investment
banks help a corporation issue securities. First, it advises the corporation on which type of
securities to issue (stocks or bonds); then it helps sell (underwrite) the securities by purchasing
them from the corporation at a predetermined price and reselling them in the market. Investment
banks also act as deal makers and earn enormous fees by helping corporations acquire other
companies through mergers or acquisitions.

Financial markets
Financial markets are the centres or arrangements that provide facilities for buying and selling of
financial products, like stocks and bonds. Financial markets perform the essential economic
function of channelling funds from households, firms, and governments that have saved surplus
funds by spending less than their income to those that have a shortage of funds because they
wish to spend more than their income. The flow of funds is shown below in the schematic
representation. In direct finance borrowers borrow funds directly from the lenders in the financial
markets by selling them securities. In indirect finance the financial intermediaries intervene.
Financial markets are critical for producing an efficient allocation of capital (wealth, either
financial or physical that is employed to produce more wealth) which contributes to higher
production and efficiency for the overall economy. Next the structure or classification of
financial markets is discussed.

Debt and Equity versus Derivative Markets – a firm or an individual can obtain funds in a
financial market by either issuing a debt instrument or equities. The most common method is to
issue debt instruments, such as a bond or a mortgage which is a contractual agreement by the
borrower to pay the holder of the instrument fixed payments at regular intervals until a specified
date when the final payment is made, called the maturity date. The maturity of a debt instrument
is the number of years until the instrument’s expiration date. Debt instruments with maturity less
than year are called short-term instruments. When more than one year but less than ten years
then the instrument is of intermediate-term and it is long-term if maturity is longer than ten
years.

Equities such as common stocks are claims to share in the net income (income after expenses and
tax) and the assets of a business. Equities often make periodic payments to their holders called
dividends and are considered long term securities because they don’t have any maturity date. The
disadvantage with equities is that an equity holder is a residual claimant, i.e. the corporation must
pay all its debt holders before it pays its equity holders. The advantage of holding equities is that
equity holders benefit directly from any increase in corporation’s profitability or asset value.

Derivative markets are the markets where investors trade instruments like futures and options,
which are primarily designed to transfer risk. In debt and equity markets actual claims are bought
and sold for immediate cash payments, while in derivative markets investors make agreements
that are settled later.

Primary and Secondary Market - A primary market is a financial market in which new issues of
a security, such as a bond or a stock, are sold to initial buyers by the corporation or government
agency borrowing the funds. The primary markets for securities are not well known to the public
because the selling of securities to initial buyers often takes place behind closed doors. An
important financial institution that assists in the initial sale of securities in the primary market is
the investment bank. It does this by underwriting securities: It guarantees a price for a
corporation's securities and then sells them to the public.

A secondary market is a financial market in which securities that have been previously issued
can be resold, e.g. BSE, NSE in India and New York Stock Exchange and NASDAQ in US.
Other examples of secondary markets are foreign exchange markets, futures markets, and options
markets. When an individual buys a security in the secondary market, the person who has sold
the security receives money in exchange for the security, but the corporation that issued the
security acquires no new funds. A corporation acquires new funds only when its securities are
first sold in the primary market. Nonetheless, secondary markets serve two important functions.
First, they make it easier and quicker to sell these financial instruments to raise cash; that is, they
make the financial instruments more liquid. The increased liquidity of these instruments then
makes them more desirable and thus easier for the issuing firm to sell in the primary market.
Second, they determine the price of the security that the issuing firm sells in the primary market.
The investors who buy securities in the primary market will pay the issuing corporation no more
than the price they think the secondary market will set for this security. The higher the security’s
price in the secondary market, the higher the price that the issuing firm will receive for a new
security in the primary market, and hence the greater the amount of financial capital it can raise.
Conditions in the secondary market are therefore the most relevant to corporations issuing
securities.

Centralised Exchanges, Over-the-Counter Markets, and Electronic Communication Networks

(ECNs) – exchanges are the central locations where the buyers and the sellers or their agents or
brokers physically meet to conduct trades. In an over-the-counter (OTC) market, dealers at
different locations who have an inventory of securities stand ready to buy and sell securities
"over the counter" to anyone who comes to them and is willing to accept their prices. Because
over-the-counter dealers are in computer contact and know the prices set by one another, the
OTC market is very competitive. Many common stocks are traded over-the-counter, although a
majority of the largest corporations have their shares traded at organized stock exchanges.

In the US, though NASDAQ is a dealer based exchange it is not classified as an OTC market.
Rather, OTC markets generally list small companies and often these small companies have
‘fallen off’ from more organized exchanges, i.e. unlisted companies. In India NSE provides a
nationwide, on-line fully automated screen based trading system (SBTS) or platform like
NASDAQ. It is the first exchange in the world to use satellite communication technology for
trading.

The organization of secondary financial markets is changing rapidly. Today we have electronic
communication networks like Instinet and Archipelago. ECNs are part of a class of exchange
called alternative trading systems (ATS). They connect buyers and sellers directly and thus
because of a reduced transaction cost, they pose a competitive threat to the traditional exchanges.
Also, ECNs allow trading activities to continue beyond the usual schedule of centralised
exchanges. ECNs trade stocks that are listed with the centralised exchanges. However, they
primarily serve institutional investors.

Money and Capital Markets – these markets are defined in terms of the maturity of the securities
trades. Only short-term debt instruments are traded in money market whereas in the capital
market long term debt and equity instruments are traded. Since, money market instruments are
short-term, they are more liquid. Also, they are relatively safer investments because they tend to
have lesser fluctuations in their prices compared to long-term securities. Consequently,
corporations and banks actively use the money market to earn interest on temporarily available
surpluses. Capital market instruments are primarily held by insurance companies or pension
funds which are more certain about availability of funds in future.