KGiSL INSTITUTE OF TECHNOLOGY

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UNIT I - FINANCIAL MARKETS IN INDIA

INTRODUCTION
Financial System of any country consists of financial markets, financial intermediation and
financial instruments or financial products. This paper discusses the meaning of finance and
Indian Financial System and focus on the financial markets, financial intermediaries and
financial instruments. The brief review on various money market instruments are also covered in
this study. The term "finance" in our simple understanding it is perceived as equivalent to
'Money'. We read about Money and banking in Economics, about Monetary Theory and Practice
and about "Public Finance". But finance exactly is not money; it is the source of providing funds
for a particular activity. Thus public finance does not mean the money with the Government, but
it refers to sources of raising revenue for the activities and functions of a Government. Here
some of the definitions of the word 'finance’ both as a source and as an activity i.e. as a noun and
a verb.
INDIAN FINANCIAL SYSTEM
The economic development of a nation is reflected by the progress of the various economic units,
broadly classified into corporate sector, government and household sector. While performing
their activities these units will be placed in a surplus/deficit/balanced budgetary situations.
There are areas or people with surplus funds and there are those with a deficit. A financial
system or financial sector functions as an intermediary and facilitates the flow of funds from the
areas of surplus to the areas of deficit. A Financial System is a composition of various
institutions, markets, regulations and laws, practices, money manager, analysts, transactions
Financial System;
The word "system", in the term "financial system", implies a set of complex and closely
connected or interlined institutions, agents, practices, markets, transactions, claims, and liabilities
in the economy. The financial system is concerned about money, credit and finance-the three
terms are intimately related yet are somewhat different from each other. Indian financial system
consists of financial market, financial instruments and financial intermediation. These are briefly
discussed below;

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FINANCIAL MARKETS
A Financial Market can be defined as the market in which financial assets are created or
transferred. As against a real transaction that involves exchange of money for real goods or
services, a financial transaction involves creation or transfer of a financial asset. Financial Assets
or Financial Instruments represents a claim to the payment of a sum of money sometime in the
future and /or periodic payment in the form of interest or dividend.
1. Money Market- The money market ifs a wholesale debt market for low-risk, highly-liquid,
short-term instrument. Funds are available in this market for periods ranging from a single day
up to a year. This market is dominated mostly by government, banks and financial institutions.
2. Capital Market - The capital market is designed to finance the long-term investments. The
transactions taking place in this market will be for periods over a year.
3. Forex Market - The Forex market deals with the multicurrency requirements, which are met
by the exchange of currencies. Depending on the exchange rate that is applicable, the transfer of
funds takes place in this market. This is one of the most developed and integrated market across
the globe.
Credit Market- Credit market is a place where banks, FIs and NBFCs purvey short, medium and
long-term loans to corporate and individuals.
CONSTITUENTS OF A FINANCIAL SYSTEM
FINANCIAL INTERMEDIATION
Having designed the instrument, the issuer should then ensure that these financial assets reach
the ultimate investor in order to garner the requisite amount. When the borrower of funds
approaches the financial market to raise funds, mere issue of securities will not suffice. Adequate
information of the issue, issuer and the security should be passed on to take place. There should
be a proper channel within the financial system to ensure such transfer. To serve this purpose,
Financial intermediaries came into existence. Financial intermediation in the organized sector is
conducted by a widerange of institutions functioning under the overall surveillance of the
Reserve Bank of India. In the initial stages, the role of the intermediary was mostly related to
ensure transfer of funds from the lender to the borrower. This service was offered by banks, FIs,
brokers, and dealers. However, as the financial system widened along with the developments
taking place in the financial markets, the scope of its operations also widened. Some of the
important intermediaries operating ink the financial markets include; investment bankers,
underwriters, stock exchanges, registrars, depositories, custodians, portfolio managers, mutual
funds, financial advertisers financial consultants, primary dealers, satellite dealers, self-
regulatory organizations, etc.
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Though the markets are different, there may be a few intermediaries offering their services in
more than one market e.g. underwriter. However, the services offered by them vary from one
market to another. Characteristics of a well-functioning financial system The financial system
plays a vital role in supporting sustainable economic growth and meeting the financial needs of
Australians. It does this by facilitating funding, liquidity and price discovery, while also
providing effective risk management, payment and some monitoring services.
The Inquiry believes the financial system achieves this most effectively when it operates in an
efficient and resilient manner and treats participants fairly. This occurs when participants fulfill
their roles and responsibilities in a way that engenders confidence and trust in the system.
The financial industry makes a considerable contribution to employment and economic output in
Australia. However, the Inquiry believes the focus of financial system policy should be primarily
on the degree of efficiency, resilience and fairness the system achieves in facilitating economic
activity, rather than on its size or direct contribution (such as through wages and profits).
EFFICIENCY
An efficient financial system is fundamental to supporting Australia’s growth and productivity.
An efficient system allocates Australia’s scarce financial and other resources for the greatest
possible benefit to our economy, promoting a higher and more sustainable rate of productivity,
and economic growth. The Inquiry is concerned with three distinct, but interrelated, forms of
efficiency:
1. Operational efficiency — where financial products and services are delivered in a way that
minimises costs and maximises value. This largely depends on how effectively firms deploy
labour, capital and technology, and the regulations with which firms comply. Strong competition,
both from new entrants and incumbents, encourages firms to innovate and increase operational
efficiency to survive and prosper. This can be seen in the ongoing industry focus on deploying
new technologies in the Australian financial system to improve the quality and reduce the cost of
products and services. Good policy-making can also assist operational efficiency by providing a
stable regulatory environment and well-designed regulation that takes into account its likely
effect on industry.
2. Dynamic efficiency — where the financial system delivers price signals that induce the
optimal balance between consumption and saving (deferred consumption). At times, policy
intervention may be required to overcome behavioural biases that impede an economy’s ability
to allocate resources with dynamic efficiency. For example, Australia’s compulsory
superannuation system was introduced, in part, to overcome the tendency of individuals to
underestimate the value of deferred consumption for long periods, such as for retirement.
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3. Resilience
Resilience refers to the financial system’s capacity to adjust to both the normal business cycle
and a severe economic shock. A resilient system does not preclude failure, nor necessarily imply
price stability. Rather, a resilient system can adjust to changing circumstances while continuing
to provide core economic functions, even during severe but plausible shocks. In a resilient
system, individual institutions in distress should be resolvable with minimal costs to depositors,
policy holders, taxpayers and the real economy.
Occasional episodes of financial instability are inherent in a market economy and are typically
associated with asset price volatility, high levels of leverage, under-pricing of risks and
mismatches between assets and liabilities. History suggests that events of instability will
continue to occur, but their timing, severity and causes cannot be reliably predicted.
4. Fair treatment
Fair treatment occurs where participants act with integrity, honesty, transparency and non-
discrimination. A market economy operates more effectively where participants enter into
transactions with confidence that they will be treated fairly.
CULTURE OF FINANCIAL FIRMS
Since the GFC, a persistent theme of international political and regulatory discourse has been the
breakdown in financial firms’ behaviour in failing to balance risk and reward appropriately and
in treating their customers unfairly. Without a culture supporting appropriate risk-taking and the
fair treatment of consumers, financial firms will continue to fall short of community
expectations. This may lead to ongoing political pressure for additional financial system
regulation and the undermining of confidence and trust in the financial system.
An organisation’s culture reflects its accumulated knowledge, beliefs and values in a way that
sets norms for the behaviour of its employees and their decision making. Organisational
objectives, business strategies and systems all influence employees’ behaviour, which reflects on
an organisation’s culture. Leaders and their governing bodies determine organisational culture
through their own conduct and design of objectives, strategies and systems. This creates
competitive advantage.
The Inquiry considers that industry should raise awareness of the consequences of its culture and
professional standards, recognising that, responsibility for culture in the financial system
ultimately rests with individual firms and the industry as a whole. Culture is a set of beliefs and
values that should not be prescribed in legislation. To expect regulators to create the ‘right’
culture within firms by using prescriptive rules is likely to lead to over-regulation, unnecessary

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compliance cost and a lessoning of competition. The responsibility for setting organisational
culture rightly rests with its leadership.
Components of Indian Financial System
The financial system of an economy provides the way to collect money from the people who
have it and distribute it to those who can use it best. So, the efficient allocation of economic
resources is achieved by a financial system that distributes money to those people and for those
purposes that will yield the best returns.
1. Financial Institutions: It ensures smooth working of the financial system by making investors
and borrowers meet. They mobilize the savings of investors either directly or indirectly via
financial markets by making use of different financial instruments as well as in the process using
the services of numerous financial services providers. They could be categorized into
Regulatory, Intermediaries, Non intermediaries and Others. They offer services to organizations
looking for advises on different problems including restructuring to diversification strategies.
They offer complete series of services to the organizations who want to raise funds from the
markets and take care of financial assets, for example deposits, securities, loans, etc.
2. Financial Markets: A Financial Market can be defined as the market in which financial assets
are created or transferred. As against a real transaction that involves exchange of money for real
goods or services, a financial transaction involves creation or transfer of a financial asset.
Financial Assets or Financial Instruments represent a claim to the payment of a sum of money
sometime in the future and /or periodic payment in the form of interest or dividend. There are
four components of financial market are given below:
I. Money Market: The money market is a wholesale debt market for low-risk, highly-liquid,
short-term instrument. Funds are available in this market for periods ranging from a single day
up to a year. This market is dominated mostly by government, banks and financial institutions.
II. Capital Market: The capital market is designed to finance the long-term investments. The
transactions taking place in this market will be for periods over a year.
III. Foreign Exchange Market: The Foreign Exchange market deals with the multicurrency
requirements which are met by the exchange of currencies. Depending on the exchange rate that
is applicable, the transfer of funds takes place in this market. This is one of the most developed
and integrated markets across the globe.
IV. Credit Market- Credit market is a place where banks, Financial Institutions (FIs) and Non-
Bank Financial Institutions (NBFCs) purvey short, medium and long-term loans to corporate and
individuals.

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3. Financial Instruments: This is an important component of financial system. The products
which are traded in a financial market are financial assets, securities or other types of financial
instruments. There are a wide range of securities in the markets since the needs of investors and
credit seekers are different.
SAVINGS-INVESTMENT RELATIONSHIP
The above three major functions are important for the running and development activities of any
economy. Apart from these functions, an economy’s growth is boosted by the savings-
investment relationship. When there are sufficient savings, only then can there be sizeable
investment and production activity. This savings facility is provided by financial institutions
through attractive interest schemes. The money saved by the public is used by the financial
institutions for lending to businesses at substantial interest rates. These funds allow businesses to
increase their production and distribution activities.
Growth of capital markets
Another important work of finance is to boost growth of capital markets. Businesses need two
types of capital – fixed and working. Fixed capital refers to the money needed to invest in
infrastructure such as building, plant and machinery. Working capital refers to the money needed
to run the business on a day-today basis. This may refer to the ongoing purchase of raw
materials, cost of finishing goods and transport of finished goods to stores or customers. The
financial system helps in raising capital in the following ways:
Fixed capital – Businesses issue shares and debentures to raise fixed capital. Financial service
providers, both public and private, invest in these shares and debentures to make profits with
minimal risk.
Working capital – Businesses issue bills, promissory notes etc. to raise short term loans. These
credit instruments are valid in the money markets that exist for this purpose.
Foreign exchange markets
In order to support the export and import businessmen, there are foreign exchange markets
whereby businesses can receive and transmit funds to other countries and in other currencies.
These foreign exchange markets also enable banks and other financial institutions to borrow or
lend sums in other currencies. Moreover, financial institutions can invest and reap profits from
their short term idle money by investing in foreign exchange markets. Governments also meet
their foreign exchange requirements through these markets. Hence, foreign exchange markets
impact the growth and goodwill of an economy in the international markets.