The Nature and Role o Financial System INTRODUCTION This chapter presents the bare elements of a financial system which will be discussed in all detail in the subsequent chapters. It discusses the constituents, economic developmental contribution and ‘constraints, and performance criteria of the financial system, and certain concepts in its develop- ment. STRUCTURE OF FINANCIAL SYSTEM. (he financial system or the financial sector of any country consists of (a) specialised and non- ‘specialised financial institutions, (b) organised and unorganised financial markets, and (c) finan- cial instruments and services which facilitate transfer of funds. Procedures and practices adopted jin the markets, and financial interrelationships are also parts of the system. These parts are not always mutually exclusive. For example, the financial institutions operate in financial markets and are, therefore a part of such markets. The word “system”, in the term “financial system” implies a set of complex and closely connected or intermixed institutions, agents, practices, markets, trans- actions, claims, and liabilities in the economy. The financial system is concerned about money, credit, and finance—the terms intimately related yet somewhat different from each other. Money refers to the current medium of exchange or means of payment. Credit or loan is a sum of money to be returned normally with interest; it refers to a debt of economic unit. Finance is monetary resources comprising debt and ownership funds of the State, company or person. Figure 1.1 presents a typical structure of financial system in any economy. Financial Institutions Financial institutions are business organisations that act as mobilisers and depositories of savings, and as purveyors of credit or finance, They also provide various financial-services-to-the-commu- nity. They differ from non-financial (industrial and commercial) business organisations in respect oF tei . while the former deal in financial assets such as deposits, loans, securities, and 8o on, the latter deal in real assets-such as machinery, equipment, stocks of goods. real estate, and pe distinction between the financial sector and the “real sector” should not be taken to there is something ephemeral or unproductive about finance. At the same time, it means that the role of financial sector should not be overstressed. The activities of different financial institutions may be either specialised or they may overlap; quite often they overlap. Yet, we need to classify the financial institutions and this is done on such basis as their primary activity or the degree of their specialisation with relation to savers or borrowers with whom they customarily deal or the manner of their creation. In other words, the functional, geographic, sectoral scope of activity or the type of ownership are some of the criteria which are often used to classify a large ‘number and variety of financial institutions which exist in the economy. However, it should be kept in mind that such classification is likely to be imperfect and tentative. f1.4 Financial Institutions and Markets Financial System Financial Financial Financial Markets Instruments Saakaia (Claims, Assets, Securities) ie Primary Secondary Regulatory inter Non-inter- Others mediaries_mediaries Organised ——_Unorganised Banking Non-Banking Short Medium Long Term = Term Term Primary Secondary Capital Money Markets Markets, ol Equity Market Debt Market Derivatives Market Fig. 1.1 Financial System—Various Parts and Types of Classification Classification of Financial Institutions Banking and Non-banking Institutions According fo one classification, financial institutions are divided into the banking and non-banking ones, The hanking-instiions have quite a few things in common with the non-banking ones, but their distinguishing character lies in the fact that, unlike other institutions, (a) they participate in the economy's payments mechanism, i.e. they provide transactions services, (B) their deposit liabilities constitute a major part oF the nal Framd-(e) they can, as a whole, create depenits or credit; which is monty. Banks, subject to'legal reserve requirements, ean aiheos crc it by creating claims against themselves, while other institutions can lend only oat of eacunees put at their disposal by the savers. The distinction between the two has been highlighted by Sayers by characterising the former as “creators” of credit, and the latter as mere “purveyors” of credit.! While the banking system in India comprises the-commercial. ks _and co-operative banks, the examples of non-banking financial institutions are Life Insurance Corporation (LIC), Unit Trust of India (UTD, and Industsial Development Bank of India (DBI) ~~ "Sayers, RS., Modern Banking, Oxford University Press, Oxford, 1968,— — The Nature and Role of Financial System 1.5 intermediaries and Non-intermediaries ‘The financial institutions are also classified as intermediaries and non-intermediaries. As the term indicates, mtermedianies intetmediate between sav ste ‘Yas well as mobilise savings; their [abilities are towards.the aioe sass while det assts are from the investors or borrowers. Non-intermediary institu- tions do the Toan business but their resources are not directly obtained from the saves. All banking institutions are intermediaries. Many non-banking institutions also act as intermediaries and when they do so they are known as non-banking financial intermediaries (NBFI), The UTI, LIC and GIC are some_of-the-NBFIs in_India. The non-intermediary institutions like IDBI, IFC, and NAI have come into existence because of governmental efforts to provide assistance Tor specific pur poses, sectors.and regions; their creation as a matter of policy has been motivated by the philoso- phy that the credit needs of certain borrowers might not-be-otherwise-adequately-met by-the-usual private institutions, Since they have been set up by the government, we would call them Non- Banking Statutory Financial Organisations (NBSFO). Certain significant changes which have, of late, taken place in the nature of NBSFOs have been indicated in Chapter 15. Financial Markets Financial markets are the centres or arrangements that provide facilities for-buying. and. selling.of financial claims and services. The corporations, financial institutions, individuals, and govern- ‘nents trade in financial products on these markets either directly or through brokers and dealers on organised exchanges or off-exchanges. The participants on the demand and supply sides of these markets are financial institutions, agents, brokers, dealers, borrower ers who are inter-linked by the laws, contracts, covenants, and communication networks. Classification of Financial Markets (A) Primary and Secondary Markets Financial markets are sometimes classified as primary (direct) and secondary Cindirect) markets. The primary markets deal in the new financial claims or new securities-and,therefore,-they-are-also-known as the mi Gets. On the other hand, secondary markets deal in securities already issued_or existing or outstanding. The primary markets mobilise savings and they supply fresh or additional capital to BUSINESS Units. Although secondary markets do not contribute directly to the supply of additional capital, they do so indirectly by rendering secu “Securities issued on the primary markets liquid Stock markets have-boththe-primary-ant secondary marker segments. (8) Money and Capital Markets Very often the financial markets are classified as money markets and capital markets, although there is no essential difference between the two because both perform the same function of transferring resources to the producers. This conventional distinction is based on the differences in the period of maturity of financial assets issued in these markets. Wwints et-markets dealin the shor ims (with a period of maturity of one Year or less), the capital markets does 50 in_the-long-term.(maturity-period above 1 year) claims.* Contrary to the popular usage, the capital market is co-extensive not only with the stock market; it is much wider than the stock market. Similarly, it is not always possible to include a given participant only in either of the two (money and capital) markets. Commercial banks, for example, belong to both. While treasury bills market, call money market, and commercial bills market are 2Sometimes, the analysts talk ofthe short-term (maturity period ofa year or less), the medium-term (maturity period ‘of 1. 3 or years), and the long-term (maturity period of more than 3 or S years). ‘The capital marke, then, would be said to deal in medium and long-term claims. mayuieno uy burg1.6 Financial Institutions and Markets t_ bons ck market and government bonds 1 ‘examples of the money market, stocks Ket nd derivatives market can be of capital market. arkets have also been classified into th od i \ses, financial markets I a : 1 folloy, Keeping in view nt organised, (b) formal and informal (c) official and page ing categories: (a) organist with which the words unoreaniy i ‘ise connotation 1d (d) domestic and foreign. There is no precise co n which a toroal aig aved in this context, They are quite often used interchangeably. The nc i -establis +hanges or without systemati transactions which take place outside the well-established exc! d ic ay orderly structure or_a repent. constitute unorganised oe ee Tefer to ty markets in villages or rural areas, but they exist in urban areas also. Interbank money markets ag most foreign exchange markets do not have organised exchanges. But they are not unorganisg markets in the same way the rural markets are. The informal markets are said to usually involy families and small groups of individuals lending and borrowing from each other. This descriptig cannot be strictly applied to the foreign exchange markets, but they are also mostly infor markets. The nature, meaning, and scope of activities of these types of markets will be discuss later in the book. Financial Instruments and Services As mentioned earlier, financial systems deal in financial services and claims or financial assets or securities® or financial instruments. These services and claims are many and varied in characte This is so because ofthe diversity of motives behind borrowing and lending. The stage of develop. ment of the financial system can often be judged from the diversity of financial instruments the exist in the system. It is not possible here to discuss individually the nature of various financial claims that exist in the Indian financial system. We will tackle that task later, and meanwhile ae will just touch upon the general characteristics of these claims, Financial Asset The financial asset represents_a claim sometime in future (repayment of principal) andra ponies a in the form of interest or dividend. With regard to bank deposit ot govern eer been Paymett debenture, the holder receives both the regular periodic paymens remem ond oF industrial Principal ata fixed date, Whereas with regard to ordinary share oes eRe TePAYMent of the Payments are received (which are regular in the case of perpetual tore Peel bond, only periodic case of ordinary share). nd but may be irregular in the Financial Securities Financial securities are classi ied as pri Cindirect) securities. The primary-seourities-are-issued by thee" (drect) and_ secondary Kuma savers as. ordinary shares and debentures, while the seeqnt © TVEStOTy-dizectly to. the IMAL savers-as~bank deposits, une Uities-are-issued by the > surance policies, and_so Te ey secty somctines cuses me onsin. This eae i weg fundamentally related things of phenomena. Sceurity, in one sense, ajar © describe two gj (as in the case of bond or deposit) or supply of capital in some vane fanaa °F certificate og erent, though document may take many forms, For example, i the ease of cen an gn eof gee ETE OF oan only. Another meaning of secur i a hing deposited or pledged as gua imay ee or payment of lon, which canbe forfeited in ease offre. Wis imran © illiney sense can be used as security in te laler sense ote that However, the bank pass-book °F some und: the sec indertaking ‘rity in the former~The Nature and Role of Financial System 1.7 ‘or the purpose of certain types of analysis, it is also useful to talk about ownership securities (uz. shares) and debt securities (viz, debentures, deposits). Financial ee ae from each other in respect of their investment characteristics which, ‘of course, are interdependent and interrelated. Among the investment characteristics of financial Sssets or financial products, the following are important: (J) liquidity, (li) marketability, i) reversibility, (iv) transferability, (v) transactions cos . capitil- and income uncertainty: (Wi) risk of detuutt-or tre degree ‘status, (ix) options such as, © “of return—nominal, effective, EQUILIBRIUM IN FINANCIAL MARKETS Like the general price level and relative prices in commodities markets, we have the general level and structure of interest rates which govern the financial markets. The terminology, theories, and controversies regarding the determination of the level and structure of interest rates in India would be fully discussed in the last two chapters of this book. However, it would be appropriate to briefly discuss how the equilibrium price in financial markets is theoretically determined. ‘The equilibrium in financial markets is usually determined by assuming that there would be perfect competition, and by using the well-known tool of supply and demand. (Financial markets are said to be perfect when, | (@) a large number of savers and investors operate in markets, | (@) the savers and investors are rational, {c) all operators in the market are well-informed and information is freely available to all of them, (@) there are no transactions costs, (@) the financial assets are infinitely divisible, | | (® the participants in markets have homogeneous expectations, and (GQ) there are no taxes. ‘Scat a) Under these ideal conditions, the financial markets attain the equilibrium position when the supply and demand are equal to each other ie., the supply curve and demand curve intersect ‘each other. The question which naturally arises here is the supply of and demand for what. There is a great deal of controversy among economists in this regard, and this has resulted in different theories of equilibrium price (interest rate) in financial markets. Briefly speaking, while the Classi- cal Theory holds that the supply of saving and demand for investment determine the equilibrium level of rate of interest, the Loanable Funds Theory argues that it is the supply of and demand for loanable funds which determine the equilibrium rate of interest. The Keynesian Theory explains the phenomenon under discussion in terms of supply of and demand for money, (On the whole, it can be stated that the equilibrium in financial markets is established when the expected demand for funds (credit) for short-term and long-term investments matches with the planned supply of funds generated out of saving and credit creation. In other words, the equality of total desired borrowing with the total desired lending, is necessary for establishing equilibrium rate of interest. Figure 1.2 depicts the financial markets equilibrium, In panel (A) of Fig. 1.2, (SS) curve shows the aggregate supply of funds and (DD) curve shows the aggregate demand for funds. Their intersection point E, reflects the equilibrium position at which Q amount of funds will be supplied and demanded at the equilibrium rate of interest, r. It is mayaiong uy bueg‘1.8. Financial Institutions and Markets X= Volume of Funds Y= Rate of Interest Fig. 1.2 Equilibrium in the Financial Markets to be noted that the supply curve slopes upward from left to right, which means that as the rate of interest increases (decreases), more (less) funds would be made available in the financial system. (On the other hand, the demand curve slopes downward from left to right, which means that as the rate of interest increases, the demand for finance would decline. The shifts in either the supply curve or the demand curve or both of them would result in the equilibrium rate of interest declines from r to r, The similar result iy seen tp panel (C), when int demand curve (DD) shifts tothe left (D‘D') ie., when the demand for tania declines but the other things (supply) remain the same, the rate of interest declines Determinants of Supply and Demand for Funds The question of determinants of supply and demand for funds and empirical studies that mention ‘major determinants of supply of funds is the ag, Fegate savil oi fs Sector and the government sector, in a given econ sain ais Household sector, business omy. The saving of the economic unit is equal 10SS. . The Nature and Role of Financial System 1.9 po the difference between its disposable income and the consumption expenditure in a given year. A variety of factors have a bearing on the volume of savings in the economy. The level of current and expected income, cyclical changes in income, agewise variations in income, distribution of income in the economy, degree of certainty of income, wealth, inflation, desire to provide for old age, family members, contingencies, thrift, rate of interest, and availability of savings media with preferred investment characteristics, are the relevant factors in this respect. Another major determi- nant of supply of funds is the development of banks and other financial institutions which, in turn, determine the credit multiplier. The demand for funds depend upon (A) investment in fixed and circulating (working) capital, (B) demand for consumer durables, and (C) investment in housing. The total investment demand, in tur, is determined by (@ the current level of capital stock, (Gi) capacity utilisation. (il) the desired capital stock, which is influenced by business expectations (prospects) regarding future demand for goods (sales), prices, Government policies, and profitability, (iv) availability of inter- nal funds, (¥) cost of funds, and (vi) technological changes. The demand for consumer durables depends upon (a) changes in tastes and preferences, (b) fashion, (€) demonstration effect, and (@) cost of funds. It has to be borne in mind that the equilibrium refers to ideal conditions in financial markets. However, in reality, the situation in financial markets in different countries differs from ideal conditions in varying degrees. The finan markets are characterised by many imperfections, restrictive practices, and externalities. We witness the existence ‘of transactions costs, lack of information, limited number of operators, direct and indirect intervention by the authorities, and so fon. It is often found that the authorities determine the volume of supply of funds, allocation of funds, and the cost of funds administratively through direct physical regulations and controls. Therefore, the interest rate in practice differs, often quite substantially, from the rate of interest determined theoretically under ideal conditions. Consequently, the financial markets tend to expe- Fience either the excess demand for or excess supply of funds, continuously. Panel (D), in Fig. 1.2 gives an idea about such a phenomenon. When the rate of interest is administratively fixed at the level, r’ which is lower than the free market equilibrium rate of interest, it results in the excess demand for funds and the reduction in the supply of funds, In such a situation, the authorities try to match the supply of and demand for funds, by resorting to direct allocation of credit or by credit rationing. FINANCIAL SYSTEM AND ECONOMIC DEVELOPMENT ‘The role of financial system in economic development has been a much discussed topic among economists Is it possible to influence the level of national income, employment, standard of living, Gnd social welfare through variations in the supply of finance? In what way financial development itself is affected by economic development? ‘There is no unanimity of views on such questions. A rec existing theory on this subject has not given any generally accepted model to describe the relation- ship between i wnt’, The importance of finance iff development depends upon the desired nature of development. Inthe environment-friendly, appropriate-technol- ogy-based_ decentralised Alternative Development Model, finance is not a factor of crucial or critical imy ce. But even in a cot lel of modern indust |. the perceptions in ent literature survey concluded that the ‘Femmes Niles, “Financial Development and Economic Growth: A Survey of the Literature”, International Journal of Development Banking, January 1994 uy Leg1.10 Financial Institutions and Markets —— . ¢ finance is not important at all. The opposite viey ionary view. It may be pointed out th favour of the third view also. Let yy this regard vary a great deal. One view holds that regards it to be very important. The third school takes a cauti there is a considerable weight of thinking and evidence in briefly explain these viewpoints one by one. In his model of economic growth. Solow has argu the increase in labour and capital but from the techni a money and finance and the policies about them cannot contribute to ed that growth results predominantly not from cal progress, which is exogeneous. Therefore, he growth process. Effects of Financial System on Saving and Investment ‘The production function is the link between finance and econori development. a been argued that men, materials, and_money_are_cru inputs in production activities. The human capital and physical-capital can be bought and developed with money. Ina Sense, therefore, money, credit, and finance are the I em, Given the real resources and suitable attitudes, @ well-developed financial system, i aceeleration Sf economic development through three routes. First, technical progress is endogeneous; human and physical capital are its important sources; and the increase in them require “higher saving and investment-hich the financial system helps achieve. Second; the financial system contributes to growth not only via techt progress but also in its own right. The economic development greatly depends on the rate of capital formation, The relationship between capital and output is Strong-direct-and-monotonic (the position which is sometimes referred to as “capital fundamental. ism"). Now, the capital formation depends on whether finance is made available. in.time, in ‘adequate quantity. and on favourable terms—all-of Which@ good financial system could.achieve, Third, it also enlarges the marketS-OVer space and time; it enhances the efficiency.of.the function of medium of exchange-and thereby helps in-economic-development. ‘The importance of finance and financial system in economic development can be understood better if we study various theories of the impact of financial development on savings and invest- ment. The following theories are relevant in this context: (a) The Classical Prior Voluntary Saving Theory, (b) Credit Creation Theory, (¢) Forced Saving or Inflationary Financing Theory, (d) Financial Repression Theory, (e) Financial Liberalisation Theory. THEORIES OF THE IMPACT OF FINANCIAL DEVELOPMENT ON SAVINGS AND INVESTMENT Pr r Savings Theory The Prior Savings Theory (PST) regards saving as a prerequisite or a determinant of investment, and it holds that all savings in the economy can find investment outlets. It stresses the need for ‘appropriate monetary policy and fiscal policy for promoting and mobilising savings voluntarily for investment and growth. It is believed that since investment is a s i investment which is not financed by prior savin development. This theory does not subscri averse to inflation, it advocates control of inflation, and su positive real interest rates to encourage savin; money in the growth process. __ Now, the financial system has both the scale and structur increases the rate of growth (volume) of saving and invest consumption, any igs will generate inflation and not real income oF is needed for growth: it is uggests a policy of reasonably high is by the public. PST believes in the neutrality of re effect on saving and investment. It nent, and makes their composition,