Module 1 - Syllabus
• Financial system and markets:
objectives of financial system-
Concepts of financial system-
Development of financial systems in India-
Weakness of Indian financial system
According to Prasanna Chandra, “financial system consists of a variety of
institutions, markets and instruments related in a systematic manner
and provide the principal means by which savings are transformed
• The system that allows the transfer of money between savers and
Van Horne defined a financial system as, “the system to allocate savings
efficiently in an economy to ultimate users either for investment in real
assets or for consumption”.
• It is a complex, integrated set of subsystems. These subsystems are
Financial Institutions, Markets and Instruments.
• Financial system is a set of complex & closely connected with financial
institution, financial markets, financial instrument, & financial services
• Process by which money flows from savers to users.
• Transfer of money between investors and borrowers.
• Helps in the formation of capital.
• Meets the short term and long term capital needs of households,
corporate houses, govt and foreigners.
• Its responsibility is to mobilize the savings in the form of money and
invest them in the productive manner.
CONCEPTS OF FINANCIAL SYSTEM
• A financial system (within the scope of finance) is a system
that allows the exchange of funds
between lenders, investors, and borrowers.
• Financial systems operate at national, global, and firm-
• They consist of complex, closely related services, markets,
and institutions intended to provide an efficient and regular
linkage between investors and depositors.
FUNCTIONS OF FINANCIAL SYSTEM
• Saving mobilisation
• Liquidity function
• Payment function
• Capital formation
• Risk protection
• Information function
• Transfer function
• Reformatory functions
• Other functions
Role and Importance of Financial System in
It links the savers and investors
It helps to monitor corporate performance.
It provides a mechanism for managing uncertainty and controlling
It provides a mechanism for the transfer of resources across
It offers portfolio adjustment facilities
(provided by financial markets and financial intermediaries)
It helps in lowering the transaction costs and increase returns.
It promotes the process of capital formation.
• It helps in promoting the process of financial deepening and
(Financial deepening means increasing financial assets as a
percentage of GDP and financial broadening means building an
increasing number and variety of participants and instruments.)
• To provide a payment system,
• To give money time value,
• To offer products and services to reduce financial risk or to
compensate risk-taking for desirable objectives,
• To collect and disperse information that allows the most
efficient allocation of economic resources,
• To create and maintain financial market that provide prices,
which indicates how well investments are performing, which
also determines the subsequent allocation of resources, and
to maintain economic stability.
(i) Financial Assets
• A financial assets is one which is used for production or consumption or for further
creation of assets.
• A non-physical assets, such as a security, certificate, or bank balance. opposite
of non-financial asset.
• For instance, A buys equity shares and these shares are financial assets since they
earn income in future.
Important conditions must be met
• Something you can own
• Something of monetary value
• That monetary value is derived from a contractual claim
Classification of Financial Assets
I. Marketable assets :- Assets which can be easily transferred from one person
to another without much constraints.
Examples:- Shares of listed companies, Government securities, bonds of
public sector undertakings etc.
II. Non-marketable assets :- On the other hand, if the assets cannot be
transferred easily, they come under this category.
Examples are provident funds, pension funds, National Savings Certificates,
insurance policies etc.
Another classification is as follows:
• Short Term Financial Assets
(Money Market Instruments)
• Long Term Financial Assets
(Capital Market Instruments)
(II) Financial Intermediaries
The term financial intermediary includes all kinds of organizations which
intermediate and facilitate financial transactions of both individual and
It refers to all kinds of financial institutions and investing institutions which
facilitate financial transactions in financial markets.
Types of Financial Intermediaries
• Capital Market Intermediaries : These intermediaries mainly provide long
term funds to individuals and corporate customers. They consist of term
lending institutions like financial corporations and investing institutions like
• Money Market Intermediaries : Money market intermediaries supply only
short term funds to individuals and corporate customers. They consist
commercial banks, co-operative banks, etc.
III. FINANCIAL MARKET
• Market where entities market where entities can
trade financial securities, commodities, at low transaction costs
and at prices that reflect supply and demand.
• It is a place where funds from surplus units are transferred to deficit units.
• It is a market for creation and exchange of financial assets
• They are not the source of finance but link between savers and investors.
• Corporations, financial institutions, individuals and governments trade in
financial products on this market either directly or indirectly.
FUNCTIONS OF FINANCIAL MARKET
1. To facilitate creation and allocation of credit and liquidity.
2. To serve as intermediaries for mobilisation of savings.
3. To help in the process of balanced economic growth.
4. To provide financial convenience.
5. To provide information and facilitate transactions at low cost.
6. To cater to the various credits needs of the business organisations
Classification of Financial Market
• On the basis of maturity of claims
( Money market & capital market)
• On the basis of seasoning of claim
( Primary market & secondary market)
• On the basis of structure or arrangements
(Organised markets & unorganised markets)
• On the basis of the type of financial claim
(Dept market & Equity market)
• On the basis of timing of delivery
(Cash / Spot market & Forward/Future market)
• Other Types
Foreign exchange market
a) UNORGANISED MARKETS
In these markets there are a number of money lenders, indigenous bankers, traders
etc., who lend money to the public.
Indigenous bankers also collect deposits from the public. There are also private
finance companies, chit funds etc., whose activities are not controlled by the RBI.
Recently the RBI has taken steps to bring private finance companies and chit funds
under its strict control by issuing non-banking financial companies (Reserve Bank)
The RBI has already taken some steps to bring the unorganized sector under the
organized fold. They have not been successful. The regulations concerning their
financial dealings are still inadequate and their financial instruments have not
b) ORGANISED MARKETS
In the organized markets, there are standardized rules and regulations governing
their financial dealings. There is also a high degree of institutionalization and
instrumentalisation. These markets are subject to strict supervision and control by
the RBI or other regulatory bodies.
These organized markets can be further classified into two. They are :
CAPITAL MARKET MONEY MARKET
• According to W.H. Husband and J.C. Dockerbay, “the capital market is
used to designate activities in long term credit, which is characterised
mainly by securities of investment type”.
• Capital market simply refers to a market for long term funds. It is a market
for buying and selling of equity, debt and other securities. Generally, it
deals with long term securities that have a maturity period of above one
• Capital market is the market for long term funds.
• This market deals in the long term claims, securities and stocks with a
maturity period of more than one year.
• A market for long term funds
• Focus on financing of fixed investments
• Main participants are mutual funds, insurance organizations,
foreign institutional investors, corporate and individuals.
• Two segments: primary market and secondary market
• Mobilisation of savings
• Capital formation
• Economic development
• Integrates different parts of the financial system
• Promotion of stock market
• Foreign capital
• Economic welfare
Importance of Capital Market
Importance of Capital Market
(i) The capital market serves as an important source for the productive use of the economy’s savings. It
mobilizes the savings of the people for further investment and thus avoids their wastage in
(ii) It provides incentives to saving and facilitates capital formation by offering suitable rates of interest
as the price of capital.
(iii) It provides an avenue for investors, particularly the household sector to invest in financial assets
which are more productive than physical assets.
(iv) It facilitates increase in production and productivity in the economy and thus enhance the economic
welfare of the society. Thus, it facilitates “the movement of stream of command over capital to the
point of highest yield” towards those who can apply them productively and profitably to enhance the
national income in the aggregate.
(v) The operations of different institutions in the capital market induce economic growth. They give
quantitative and qualitative directions to the flow of funds and bring about rational allocation of
(vi) A healthy capital market consisting of expert intermediaries promotes stability in values of securities
representing capital funds.
(vii) Moreover, it serves as an important source for technological up gradation in the industrial sector by
utilizing the funds invested by the public.
1. Industrial Securities Market
As the very name implies, it is a market for shares and debentures of existing
and new Corporate firms. Buying and selling of such instruments take
place in the market.
Eg. Equity shares or ordinary shares,
Preference shares, and
Debentures or bonds.
It is a market where industrial concerns raise their capital or debt by issuing
Subdivided into two. They are :
Primary market or New issue market
Secondary market or Stock exchange
1.1 Primary / New Issue Market
• A market for new issues i.e. a market for fresh capital.
• Provides the channel for sale of new securities, not previously available.
• Provides opportunity to issuers of securities; government as well as
• To raise resources to meet their requirements of investment and/or
discharge some obligation.
• Does not have any organizational setup
• Both the new companies and the existing companies can issue new
securities on the primary market.
• Performs triple-service function: origination, underwriting and distribution.
Primary market is a market for new issues or new financial claims. Hence it is also
called New Issue market. The primary market deals with those securities which
are issued to the public for the first time. In the primary market, borrowers
exchange new financial securities for long term funds. Thus, primary market
facilitates capital formation.
There are three ways by which a company may raise capital in a primary market.
They are :
1.2 Secondary Market/ Stock Market
• Secondary market is a market for old issues. It deals with the buying and
selling existing securities i.e. securities already issued. In other words,
securities already issued in the primary market are traded in the secondary
• Secondary market is also known as stock market. The secondary market
operates through ‘stock exchanges’. Enables corporate, entrepreneurs to
raise resources for their companies and business ventures through public
Secondary market is a market for secondary sale of securities. In other
words, securities which have already passed through the new issue market
are traded in this market. Generally, such securities are quoted in the stock
exchange and it provides a continuous and regular market for buying and
selling of securities.
This market consists of all stock exchanges recognized by the Government of
India. The stock exchanges in India are regulated under the Securities
Contracts (Regulation) Act, 1956. The Bombay Stock Exchange is the
principal stock exchange in India which sets the tone of the other stock
2. Government Securities Market
• It is otherwise called Gilt-Edged securities market.
• It is a market where Government securities are traded. In India there
are many kinds of Government Securities-short term and long term.
Long term securities are traded in this market while short term
securities are traded in the money market.
• Securities issued by the Central Government, State Governments,
Semi-Government authorities like City Corporations, Port Trusts.
Improvement Trusts, State Electricity Boards, All India and State level
financial institutions and public sector enterprises are dealt in this
3. Long Term Loans Market
• Loan which have long term repayment period
Development banks and commercial banks play a significant role in this
Long term loans market may further be classified into :
• Term loans market
• Mortgages market
• Financial Guarantees market
3.1 Term Loans Market
In India, many industrial financing institutions have been created by thee
Government both at the national and regional levels to supply long term
and medium term loans to corporate customers directly as well as
These development banks dominate the industrial finance in India. Institutions
like IDBI, IFCI, ICICI, and other state financial corporations come under
this category. They also help in identifying investment opportunities,
encourage new entrepreneurs and support modernization efforts.
3.2 Mortgages Market
The mortgages market refers to those centers which supply mortgage loan
mainly to individual customers. A mortgage loan is a loan against the
security of immovable property like real estate. The transfer of interest in a
specific immovable property to secure a loan is called mortgage.
This mortgage may be equitable mortgage or legal one. Again it
may be a first charge or second charge. Equitable mortgage is
created by a mere deposit of title deeds to properties as
security whereas in the case of legal mortgage the title in the
property is legally transferred to the lender by the borrower.
Legal mortgage is less risky.
In India residential mortgages are the most common ones. The Housing and
Urban Development Corporation (HUDCO) and the LIC play a dominant
role in financing residential projects. Besides, the Land Development
Banks provide cheap mortgage loans for the development of lands,
purchase of equipment etc. These development banks raise finance
through the sale of debentures which are treated as trustee securities.
3.3 Financial Guarantees Market
A Guarantee market is a center where finance is provided against the
guarantee of a reputed person in the financial circle. Guarantee is a
contract to discharge the liability of a third party in case of his default.
Guarantee acts as a security from the creditor’s
point of view. In case the borrower fails to repay
the loan, the liability falls on the shoulders of the
guarantor. Hence the guarantor must be known
to both the borrower and the lender and he must
have the means to discharge his liability.
TYPES OF GUARANTEES
The common forms are :
Performance Guarantee:- Performance guarantees cover the payment of
earnest money, retention money, advance payments, non-completion of
Financial Guarantee:- Financial guarantees cover only financial contracts.
In India, the market for financial guarantees is well organized. The financial
guarantees in India relate to :
(i) Deferred payments for imports and exports
(ii) Medium and long term loans raised abroad
(iii)Loans advanced by banks and other financial institutions
These guarantees are provided mainly by commercial banks, development banks,
Governments both central and states and other specialized guarantee institutions like
ECGC (Export Credit Guarantee Corporation) and DICGC (Deposit Insurance and Credit
Guarantee Corporation). This guarantee financial service is available to both individual
and corporate customers. For a smooth functioning of any financial system, this guarantee
service is absolutely essential.
Money market is a market for dealing with financial assets and
securities which have a maturity period of upto one year. In other
words, it is a market for purely short term funds.
A market for dealing in monetary assets of short term nature, less than one
Enables raising up of short term funds for meeting temporary shortage of
fund and obligations and temporary deployment of excess fund.
Major participant are: RBI and commercial banks
General Features Of A Money Market
• It is market purely for short-term funds or financial assets called near money.
• It deals with financial assets having a maturity period up to one year only.
• It deals with only those assets which can be converted into cash readily without loss and
with minimum transaction cost.
• Generally transactions take place through phone i.e., oral communication. Relevant
documents and written communications can be exchanged subsequently. There is no
formal place like stock exchange as in the case of a capital market.
• Transactions have to be conducted without the help of brokers.
• The components of a money market are the Central Bank, Commercial Banks, Non-
banking financial companies, discount houses and acceptance house. Commercial banks
generally play a dominant in this market.
Objectives of Money Market
Equilibrium mechanism for evening out short term surpluses and deficits
Focal point for influencing liquidity in economy
Access to users of short term funds at reasonable cost
• The following are the important objectives of a money market:
• To provide a parking place to employ short-term surplus funds.
• To provide room for overcoming short-term deficits.
• To enable the Central Bank to influence and regulate liquidity in the economy through its
intervention in this market.
• To provide a reasonable access to users of Short-term funds to meet their requirements quickly,
adequately and at reasonable costs.
Call Money Market
The call money market is a market for
extremely short period loans say one day
to fourteen days. So, it is highly liquid.
• The loans are repayable on demand at the option of either the lender or the
borrower. The special feature of this market is that the interest rate varies
from day to day and even from hour to hour and centre to centre. It is
very sensitive to changes in demand and supply of call loans.
In India, call money markets are associated
with the presence of stock exchanges and
hence, they are located in major industrial
towns like Bombay, Calcutta, Madras, Delhi,
Commercial Bills Market
• A commercial Bill is a short term, negotiating and self liquidating
instrument with low risk
• Dealing with Commercial Bills( Bill of exchange or trade bill)
• The commercial bills are issued by the seller (drawer) on the buyer
(drawee) for the value of goods delivered by him.
• These bills are of 30 days, 60 days or 90 days maturity.
• It is a market for bills of exchange arising out of genuine trade transactions.
• In the case of credit sale, the seller may draw a bill of exchange on the
buyer. The buyer accepts such a bill promising to pay at a later date
specified in the bill. The seller need not wait until the due date of the bill.
Instead, he can get immediate payment by discounting the bill.
Definition: Treasury Bills, also known as T-bills are the short-term money
market instrument, issued by the central bank on behalf of the
government to curb temporary liquidity shortfalls. These do not yield any
interest, but issued at a discount, at its redemption price, and repaid at par
when it gets matured.
Treasury Bills Market
Treasury Bills Market
• It is a market for treasury bills which have ‘short-term’ maturity.
• A treasury bill is a promissory note or a finance bill issued by the
• It is highly liquid because its repayment is guaranteed by the
• It is an important instrument for short term borrowing of the
1. 91 Days T-Bills
2. 182 Days T-Bills
3. 364 Days T-Bills
Short-Term Loan Market
• It is a market where short-term loans are given to corporate customers for
meeting their working capital requirements.
• Commercial banks play a significant role in this market.
• Commercial banks provide short term loans in the form of cash credit and
• Overdraft facility is mainly given to business people whereas cash credit is
given to industrialists.
• Overdraft is purely a temporary accommodation and it is given in the
current account itself. But cash credit is for a period of one year and it is
sanctioned in a separate account.
The Commercial Paper Market:
• The scheme of Commercial Paper (CP) was introduced in 1990 for
short term financing issue . They can be issued in multiples of Rs. 5
lakhs and in multiples thereof
• As per RBI guidelines, CPs can be issued on the following conditions:
a) The minimum tangible net worth of the company to be at least Rs. 4
b) The working capital limit should have been sanctioned by a bank or
• Commercial Paper or CP is defined as a short-term, unsecured money
market instrument, issued as a promissory note by big corporations
having excellent credit ratings.
• As the instrument is not backed by collateral, only large firms with
considerable financial strength are authorised to issue the instrument.
• As it is a freely transferable instrument it has high liquidity
Certificates of Deposit Market
• A CD is a time deposit with a bank.
• a money market instrument, which is negotiable and
equivalent to a promissory note.
• CDs have a specific maturity date (from three months to five
years), a stated interest rate, and can be issued in any
denomination, much like bonds.
• Most CDs assess a penalty for early withdrawal prior to the
CD’s date of maturity.
• A repurchase agreement involves the sale of a security with
an agreement to repurchase the same security back at a
higher price at a later date
• A repurchase agreement, or repo, is a sale of securities for
cash with a commitment to repurchase them at a specified
price at a future date.
Financial Rates of Return
Most households in India still prefer to invest on physical assets
like land, buildings, gold, silver etc.
Studies have shown that investment in financial assets like
equities in capital market fetches more return than investments
It is imperative that one should have some basic knowledge about
the rate of return on financial assets also.
• The return on Government securities and bonds are
comparatively less than on corporate securities due to lower risk
• The Government and the RBI determine the interest rates on
• The peculiar feature of the interest rate structure is that the
interest rates do not reflect the free market forces.
• A document that has a monetary value or represents a legally
enforceable (binding) agreement between two or more parties
regarding a right to payment of money
• Such as a check, draft, bond,
share, bill of exchange,
futures or options contract
Equity shares were earlier known as ordinary shares
• Equity shareholders have to share reward and risk associated with ownership
• Equity shareholders are the owners of the company who have control over
working of the company.
• Permanent capital:
• Voting rights
• Actual owners of the company
• They bear the highest risk.
• Equity shares are transferable
• Right to control the affairs of the company
• The liability of equity shareholders is limited to the extent of their
• They do not have any obligation regarding payment of dividend.
• In case of high profit, they get dividend at higher rate
• Preference shares are long-term source of finance.
• Get fixed rate of dividend irrespective of the volume of profit
• Preference dividend is not tax deductible expenditure.
• Do not have any voting rights.
• Have the preferential right for repayment of capital in case of winding up of
• Preference shareholders also enjoy preferential right to receive dividend.
• The dividend payable on preference shares is generally higher than
Classification of Preference Shares:
1. Convertible and Non Convertible Preference Shares:
2. Redeemable and Irredeemable Preference Shares:
• Redeemable preference shares can be redeemed or repaid after the expiry of a fixed
period or after giving the prescribed notice as desired by the company.
• Irredeemable preference shares can not be redeemed during the life time of the
3. Participating and Non Participating Preference Shares:
• Participating preference shares have the right to participate in profits of the company
apart from the fixed dividend.
4. Cumulative and Non Cumulative Preference Shares:
Dividend of cumulative preference shares will have to be paid as long as the company
earns profit in any year. Whereas, for non cumulative preference shares, a company can
skip the dividend in the year, the company has incurred losses.
• A debenture is an instrument issued by a company under its common seal
acknowledging a debt and setting forth the terms under which they are issued and
are to be paid.
• A person who buys debentures is debenture holder and creditor of the company.
• Debenture can be priced as same manner as share.
• A debenture is secured only by the issuer’s promise to pay the interest and loan
• A debt instrument issued for a period of more than one year with the purpose
of raising capital by borrowing.
• Generally, a bond is a promise to repay the principal along with interest
(coupons) on a specified date (maturity). Some bonds do not pay interest, but
all bonds require a repayment of principal.
• A bond is typically a loan that is secured by a specific physical asset.
• A banker’s acceptance (BA) is a short-term credit investment
created by a non-financial firm.
• BA’s are guaranteed by a bank to make payment.
• Acceptances are traded at discounts from face value in the
• BA acts as a negotiable time draft for financing imports, exports
or other transactions in goods.
• This is especially useful when the credit worthiness of a foreign
trade partner is unknown.
Indian Financial System
• The Indian financial system can be broadly classified into formal
(organised) financial system and the informal (unorganised) financial
• The formal financial system comprises financial institutions, financial
markets, financial instruments and financial services.
The formal financial system comprises of Ministry of Finance, RBI, SEBI and
other regulatory bodies.
The informal financial system consists of individual money lenders, groups of
persons operating as funds or associations, partnership firms consisting of
local brokers, pawn brokers, and non-banking financial intermediaries such
as finance, investment and chit fund companies.
Growth and Development of Indian Financial System
1. Nationalisation of financial institutions
2. Establishment of Development Banks
3. Establishment of Institution for Agricultural Development
4. Establishment of institution for housing finance
5. Establishment of Stock Holding Corporation of India (SHCIL)
6. Establishment of mutual funds and venture capital institutions
7. New Economic Policy of 1991
Weaknesses of Indian Financial System
• Lack of co-ordination among financial institutions
• Dominance of development banks in industrial finance
• Inactive and erratic capital market
• Unhealthy financial practices
• Monopolistic market structures
• Other factors
– Banks and Financial Institutions have high level of NPA.
– Government burdened with high level of domestic debt.
– Cooperative banks are labelled with scams.
– Investors confidence reduced in the public sector undertaking etc.,
– Financial illiteracy.
Key Elements of a Well-functioning Financial System
A strong legal and regulatory environment
Sound public finances and public debt management
A central bank
Sound banking system
Well-functioning securities market