Dr. R.

Sudha, MKU College, Madurai

Semester IV
MANAGEMENT OF FINANCIAL INSTITUTIONS - PMRJT4E

Unit I
Economic growth and Financial information – Meaning – Capital formation – Process of capital
formation – Saving, Investment and Finance – Problems of capital formulation – Role of
Financial institutions – Role as a Financial intermediary, Catalytic agent – Creator of money –
Promoter - Counsellor

CAPITAL FORMATION

Meaning
Capital formation means increasing the stock of real capital in a country. In other words, capital
formation involves making of more capital goods such as machines, tools, factories, transport
equipment, materials, electricity, etc., which are all used for future production of goods.
For making additions to the stock of Capital, saving and investment are essential.

Process of Capital Formation

In order to accumulate capital goods some current consumption has to be sacrificed. The
greater the extent to which the people are willing to abstain from present consumption, the
greater the extent that society will devote resources to new capital formation. If society
consumes all that it produces and saves nothing, future productive capacity of the economy will
fall as the present capital equipment wears out.

In other words, if whole of the current productive activity is used to produce consumer goods
and no new capital goods are made, production of consumer goods in the future will greatly
decline. To cut down some of the present consumption and wait for more consumption in the
future require far-sightedness on the part of the people. There is an old Chinese proverb, “He
who cannot see beyond the dawn will have much good wine to drink at noon, much green wine
to cure his headache at dark, and only rain water to drink for the rest of his days.”

Three Stages in Capital Formation:

Although saving is essential for capital formation, but in a monetized economy, saving may not
directly and automatically result in the production of capital goods. Savings must be invested in
order to have capital goods. In a modern economy, where saving and investment are done
mainly by two different classes of people, there must be certain means or mechanism whereby
the savings of the people are obtained and mobilized in order to give them to the businessmen
or entrepreneurs to invest in capital.

(a) Creation of Savings:

An increase in the volume of real savings so that resources, that would have been devoted to
the production of consumption goods, should be released for purposes of capital formation.
(b) Mobilization of Savings:
A finance and credit mechanism, so that the available resources are obtained by private
investors or government for capital formation.
Dr. R. Sudha, MKU College, Madurai

(c) Investment of Savings:

The act of investment itself so that resources are actually used for the production of capital
goods.

We shall now explain these three stages:

Creation of Savings:

Savings are done by individuals or households. They save by not spending all their incomes on
consumer goods. When individuals or households save, they release resources from the
production of consumer goods. Workers, natural resources, materials, etc., thus released are
made available for the production of capital goods.

The level of savings in a country depends upon the power to save and the will to save. The
power to save or saving capacity of an economy mainly depends upon the average level of
income and the distribution of national income. The higher the level of income, the greater will
be the amount of savings.

The countries having higher levels of income are able to save more. That is why the rate of
savings in the U.S.A. and Western European countries is much higher than that in the under-
developed and poor countries like India. Further, the greater the inequalities of income, the
greater will be the amount of savings in the economy. Apart from the power to save, the total
amount of savings depends upon the will to save. Various personal, family, and national
considerations induce the people to save.

People save in order to provide against old age and unforeseen emergencies. Some people
desire to save a large sum to start new business or to expand the existing business. Moreover,
people want to make provision for education, marriage and to give a good start in business for
their children.

Further, it may be noted that savings may be either voluntary or forced. Voluntary savings are
those savings which people do of their own free will. As explained above, voluntary savings
depend upon the power to save and the will to save of the people. On the other hand, taxes by
the Government represent forced savings.

Moreover, savings may be done not only by households but also by business enterprises” and
government. Business enterprises save when they do not distribute the whole of their profits,
but retain a part of them in the form of undistributed profits. They then use these undistributed
profits for investment in real capital.

The third source of savings is government. The government savings constitute the money
collected as taxes and the profits of public undertakings. The greater the amount of taxes
collected and profits made, the greater will be the government savings. The savings so made
can be used by the government for building up new capital goods like factories, machines,
roads, etc., or it can lend them to private enterprise to invest in capital goods.
Dr. R. Sudha, MKU College, Madurai

Mobilization of Savings:

The next step in the process of capital formation is that the savings of the households must be
mobilized and transferred to businessmen or entrepreneurs who require them for investment.
In the capital market, funds are supplied by the individual investors (who may buy securities or
shares issued by companies), banks, investment trusts, insurance companies, finance
corporations, governments, etc.

If the rate of capital formation is to be stepped up, the development of capital market is very
necessary. A well- developed capital market will ensure that the savings of the society-will be
mobilized and transferred to the entrepreneurs or businessmen who require them.

Investment of Savings in Real Capital:

For savings to result in capital formation, they must be invested. In order that the investment of
savings should take place, there must be a good number of honest and dynamic entrepreneurs
in the country who are able to take risks and bear uncertainty of production.

Given that a country has got a good number of venturesome entrepreneurs, investment will be
made by them only if there is sufficient inducement to invest. Inducement to invest depends on
the marginal efficiency of capital (i.e., the prospective rate of profit) on the one hand and the
rate of interest, on the other. But of the two determinants of inducement to invest-the
marginal efficiency of capital and the rate of interest—it is the former which is of greater
importance. Marginal efficiency of capital depends upon the cost or supply prices of capital as
well as the expectations of profits.

Fluctuations in investment are mainly due to changes in expectations regarding profits. But it is
the size of the market which provides scope for profitable investment. Thus, the primary factor
which determines the level of investment or capital formation, in any economy, is the size of
the market for goods.

CAPITAL FORMATION – PROBLEMS

Reason # 1. Low Level of National Income and Per Capita Income:

The root cause of capital deficiency in under-developed countries is low level of real national
and per capita income which limits to the motives of savings and investments.
Due to lack of desired investments, capital formation has no increase. Hence, due to low
production, there is low national and per capita income and, in turn, this forces to low capital
formation.

This situation tends to perpetuate itself and the poor countries continue to be poor. The low
rate of capital formation is a partial link in a vicious circle in such countries. Unless, the vicious
circle of poverty is broken, the rate of capital formation cannot be raised.

Reason # 2. Lack in Demand of Capital:

Another cause of low rate of capital formation in under-developed countries in lack of demand
of capital. In the words of Prof. Nurkse, “Low productivity in under-developed countries, people
Dr. R. Sudha, MKU College, Madurai

have low real income and, thus, purchasing power is low and so due to low demand,
investment has effect which again reduces national income and productivity and rate of capital
formation remains low”.

Reason # 3. Lack in Supply of Capital:

Like demand of capital, lack of supply of capital is responsible for low capital formation.
However, due to lack of necessary supply of capital in under-developed countries, the process
of capital formation is not boosted up. As a result, capital formation remains at low level.
Therefore, in the opinion of Prof. Nurkse, Due to low rate of real income per capita in under-
developed countries, there is low saving capability, hence, there is less capital. Due to lack of
capital, there cannot be established basic business and industries so the production falls down.

Reason # 4. Small Size of Market:

Due to small size of domestic market, investment is not encouraged in poor countries. It does
not expand the work of economic development and modern machines cannot be used as extra
quantity produced has no market access.

Reason # 5. Lack of Economic and Social Overheads:

Basic overheads like roads, buildings, communication, education, water, health etc. are
generally lacked in under-developed countries which react as improper atmosphere for the
capital formation and slow process of capital formation.

Reason # 6. Lack of Skilled Entrepreneurs:

Able and efficient entrepreneurs are not available in under-developed countries. It is the only
reason for low rate of capital formation. Due to absence of risk-taking entrepreneurs,
establishment of industries and expansion is quite limited and industrial diversification is not
carried out and no balanced development of economy is possible.

Reason # 7. Immobility of Savings:

Immobility of saving also causes low rate of capital formation. Due to lack of banking and other
credit institutions, poor countries have limited financial activities. Whatever, these financial
institutions exist, they are of small size and unable to collect the savings from distant places,
thus, resulting in no enthusiasm to savings in a society. This creates the problem of hoarding
and saving is used for non-productive purposes.

Reason # 8. Backwardness of Technology:

Under-developed countries also face the problem of technical knowledge. Production is carried
on old and less productive techniques. As a result, these countries have low productivity and
per capita production and income’s low quantity, lowers the standard of the rate of capital
formation.

Reason # 9. Demonstration Effect:

Demonstration effect also stands in the path of capital formation. Prof. Nurkse has cited the
reason of low rate of capital formation, “due to demonstration patterns of people come into
contact with best goods or superior patterns of consumption in which old demands are fulfilled
by new goods and new plans, then, they after some time fell unrest and discontent. In this way,
their knowledge grows their imagination is stimulated, new desires are awakened. By this their
Dr. R. Sudha, MKU College, Madurai

propensity to consume becomes high”.

Besides, there is tendency among people of these countries to follow the higher consumption
standard of developed countries. In fact, all these actions occur due to demonstration effect
which increases the tendency of consumption based on new ways and goods which limit the
desire and capability to save in the society.

Reason # 10. Lack of Effective Fiscal Policy:

Lack of effective fiscal policy or financial policy in under-developed countries also retard capital
formation to some extent. Burden of taxation is too much which is out of people’s capacity to
bear as their income is quite low. Besides, inflationary circumstances accrue and prices soar
extremely high.

This leads to increase in cost price of capitalized goods and not consumption goods by which
exported goods in internal market do not hold in external market in competition to best and
cheap goods. This creates the problem of unfavourable balance of trade and payment. Thus,
these countries have very low rate of economic development and capital formation.

Reason # 11. Lack of Investment Incentives:

Still another cause of the low rate of capital formation is the lack of investment incentives in
most of the under-developed countries. This leads to low rate of productivity which, in turn
restricts capital formation.

Reason # 12. Deficit Financing:

In modern times, deficit financing is considered a major resource of capital formation. But, if it
crosses its limits, then it tends to low rate of capital formation. Whenever, deficit financing is
made in the country, it leads to rise in prices and as a result, all commodities become costly.
Under this situation, it becomes hard to save as the entire amount is spent. This results in the
saving and low rate of capital formation.

Reason # 13. Unequal Distribution of Income and Wealth:

Since there is extreme unequal distribution of income and wealth in most of the under-
developed and backward countries which keep the rate of capital formation relatively low. In
fact, it restricts real investment in the economy which greatly effects the capital formation.

Reason # 14. Demographic Reasons:

In under-developed countries, the growth rate of population is very high which keeps the rate
of capital formation at a low level. It is because most part of their income is spent on bringing
up the additional numbers. Thus, there is little scope of saving and as a result, it aggravates the
growth of capital formation.
Dr. R. Sudha, MKU College, Madurai

1. Role as financial intermediary: Financial institutions play this role by providing the means and
mechanism of transferring command over resources from those who have an excess of income over
expenditure to those who can make use of the same with view of adding to the volume of productive
capital. They provide a convenient and effective link between savings and investment.

In an underdeveloped economy, the role of these institutions as mobilizers of savings become more
pronounced in view of the fact that there are large numbers of savers, each with small amount of
savings. These savers are generally reluctant to invest their surplus income because of their lack of
adequate knowledge about complicated investment affairs. Moreover their resources are small. So they
are exposed to great risk which constrains them from investing their savings. Financial institutions take
care of these problems. The investment policies of these institutions focus on diversification of these
investments in terms of securities, units, industries etc. Thus the total investments portfolio of the
institution will probably have lower risk element than if thousands of individuals invested their limited
funds in one or few business firms.

2. Role as a catalytic agent: Financial institutions play the role of catalytic agent bringing about the
economic and social change in a country through dynamism ad innovativeness in their operations.
Sensing well established fact that development of physical and social infrastructure is essential pre-
requisite for rapid economic advancement and burgeoning funds required to execute infrastructural
projects, financial institutions extend support to the government to finance the projects of national
importance. In fact rate of growth of an economy depends upon the speed with which financial
institutions respond to the infrastructural demand of the country. Besides, financial institutions can
catalyze the social change which is imperative for all around economic growth of a developing country.
Through introduction of special assistance schemes for weaker and helpless sections and relatively
isolated segments of society, financial institutions play a crucial role in vanishing poverty and improving
the standard of living of the people.

3. Role as a creator of money: financial institutions apart from playing the role of intermediary and
catalyst agent create money and thus act as a catalyst in the process of money supplier. Through
Dr. R. Sudha, MKU College, Madurai

acceptance of public deposits and lending money against it for funding transactions they create further
deposits.

4. Role as a promoter: entrepreneurship is one of the important sinews of economic growth of a

country. One of the serious bottlenecks in an underdeveloped country is dearth of entrepreneurship. So
to accelerate the pace of growth of such country, it is imperative to assess growth potentialities of
various regions of the country in the light of natural resources, and infrastructural facilities, identify
specific project ideas, evaluate these ideas so as to determine their feasibility in financial and non
financial terms. The above task requires considerable skill, knowledge and experience and substantial
amount of finance which is beyond the means and competence of entrepreneurs in underdeveloped
countries. As such, financial institutions play the role of a promoter to foster the economic growth in the
country. As a promoter, these institutions under take comprehensive growth potential surveys of the
existing industrial structure of the various parts of the country, analyze the demand and supply position
of the various projects, and identify industrial ventures which can be established in the different regions
in the near future. In order to ensure that these projects are implemented properly, financial institutions
take the responsibility of identifying individuals with entrepreneurial traits and motivate them to an
entrepreneurial career by providing training facilities and dispensing financial, technical and managerial
support so that the latter may set up the industries.

5. Role as a counselor: financial institutions also play significant role, though indirectly in accelerating
the pace of growth, by advising the corporate enterprises on when to exit a business and how to better
manage their portfolio.