L/LO/202

Overview of the Financial System

I ntroduction
N/St-310 Financial lnstitutlons and Markets Role of the financial system
. Flow of funds (surplus/deficit spending units)
Topic L: Overview of the Financial System . Econonric units
lransferring funds from SSUs to DSUs
january 5,2024 . Dlrect financing
. lndirect financing
. Benefits of financial internlediation
'Types
of financial intermediaries
. Deposit taking institutions
. Nonbank financial corporations
. Other financial institutions

International organizations

t 2

*O-verview of the Financial System ln-troduction

Types of financial markets 'lhe role
. of the financial system
Primary and secondary markets . Gather money from people and
. Organized and over-the-counter markets businesses that currently have more
. futures and option markets money than they need
. Transfer it to those that can use it for either business or consumer
. Foreign exchange markets
. lnternational and domestic markets expenditures
. Money and capital markets 'Ihis flow of funds through
financial markets and institutions in an
Financial market efficiency economy affects business profits, the rate of inflation, interest rates,
. Allocational eff iciency and the production of goods and services
. Informational efficiency
. Operational efficiency Larger the flow of funds and more efficient the financial system,
greater the economic output and welfare in the economy
Risks faced by financial institutions
. Credit, liquidity, foreign exchange, political, reputational, environmental

3 4

ln-troduction
_-1919,! qctlon : Fi na ncia I System
Financial system consists of Financial markets
. Various markets facilitate the flow of funds among the various market
Financial markets
participants through the buying and selling of financial products
Financial institutions . Each market accommodates different types of financial products, with
some dealing only in new ones; and others in specific type, maturity,
Money location, and size (value)

[:inancial institutions
. Commercial banks and non-banking financial companies
. Vary widely in size, reputation, product line, and international presence

Money
. lmportant as a medium of exchange for efficient financial system to exist
. Overcomes the divisibility problem

5 6

lntrod uction
Sally gets admission in a university to do a two-year master,s course
Needs Rs 10 lakhs for course fees
Does not have enough funds to pay fees and to meet other expenses
that will be incurred during the studies
7 8
lntroduction
Sally deposits Rs 7 lakhs in a term deposit
She expects to receive 5.1 percent interest on that
t.ike Sally there are many individuals who deposit funds with banks
to earn interest income
Bank has this large pool of funds, which bank can use to make new
investments or lend to businesses and individuals
9 10
lntrod uction
Consistent with its goal of profit maximization, the bank ultimately
decided to make the caf6 loan
. The project has a favorable rate of return and the owner's high credit
rating standing
Other loan applications were rejected because applicants had poor
credit ratings or the projects' rates of return were not as favorable as
that of the caf6 project
Allocational, informational, and operational efficiency?
11.
t/Lo/202
I ntrod uct i on
Sally gets admission in a university to do a two-year master's course
Needs Rs 10 lakhs for course fees
Does not have enough funds to pay fees and to meet other expenses
that will be incurred during the studies
She decides to borrow Rs 10 lakhs from a bank
After obtaining some information (such as that related to course,
past borrowings, future income), bank lends Rs 10 lakhs to Sally
Sally only needs to pay Rs 3 lakhs in her first year and remaining
amount (Rs 7 lakhs) to pay fees in the second year
Introd uction
At the same time that the bank received Sally's Rs 7 lakhs, it was
reviewing applications from the local caf6 for a Rs 25 lakh loan to
expand its operations
The loan interest rate is 8 percent, payable in five years
Money from Sally's deposit is pooled with the money from other
deposits to provide the funding
The bank is happy with the caf6 loan at 8 percent
. lt has borrowed the money for 5.1 percent (from Sally and its other
depositors), earning a 2.9 percent (8 - 5.1) gross profit margin
Role of the Financial System
Financial markets are just like any other kind of market
. ln financial markets, people buy and sell financial instruments such as
stocks and bonds
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 1./to/202

[o-lg,of the Financial System: Financial Markets Role of the Financial System: Financial Markets
Financial markets: Primary functions Financial markets: Primary functions
Facilitate the flow of funds f:ocilitote the flow ol funds
Provide the mechanism for the settlement of transactions SSUs supply surplus funds to the financial markets in return for
Generate and disseminate information that assists decision making financial instruments

Provide means for the transfer and management of risk The markets then provide these funds in return for financial
instruments to those who require additional funds
Provide ways of dealing with the incentive problems that arise in - i,.rlri.
i;,ri :.i1 r:r.j.
financial contracting , i{1 .,. irtr.

13 1.4

Role of the Financial System: Financial Markets
Financial markets: Primary functions
Facilitate the flow of funds
Financial institutions allow the flow of funds from savers or surplus
spending units (SSUs) to borrowers or deficit spending units (DSUs)
. Financial institutionst Such as commercial banks and life insurance
compa n ies
They are called financial intermediaries because they are in
between the parties that want to buy and sell financial instruments
. These are the firms that most consumers transact with when they seek
financial services
Role of the Financial System: Financial Markets
Financial markets: Primary functions
Locilitate the flow of funds
lhe role of the financial systemis to permit the flow and efficient
allocation of funds throughout the economy
For this system to be efficient, it requires sufficient volume (many
borrowers and many lenders)
The greater the flow of funds, the greater possible accommodation
of individual preferences for spending and saving

15 16

Role of the Financial System: Financial Markets Role of the Financial System: Financial Markets
Financial markets: Primary functions Financial markets: Primary functions
Facilitote the flow of funds: SSUs expect weolth creation Facilitote the flow of funds: SSUs expect weolth creotion
SSUs forego current consumption and accrue savings that are then Where to invest?
invested in the financial markets in return for financial instruments
. These financial instruments are expected to provide some return or Savings account
income to the SSUs to compensate them for forgoing consumption
Ierm deposit
This return represents an increase in wealth, which can then be used
Bonds
later or reinvested in financial instruments to generate additional
wealth Sha res

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lg]g-ot the Financial System: [:inancial Markets Role of the [:inancial System: Financial Markets
Financial markets: Primary functions Financial markets: Primary functions
Focilitote the flow of funds: SSIJs expect weolth creotion Focilitote the flow of funds: Risk-Return
Where to invest? SSUs have different risk preferences and can be classified as either
Ri sk-retu rn risk averse, risk neutral, or risk taking

Timing of the cash flows Risk takers expect to be compensated with higher returns while risk
averse investors will accept lower return to avoid risk
t.iq u i dity

19 20

*Elq of the Financial System: Financial Markets Role of the Financial System: Financial Markets
Financial markets: Primary functions Financial markets: Primary functions
Focilitote the flow of funds: Risk-Return Facilitote the flow of funds: Risk-Return
Drirast,: ilao :;ta s^\l1a9 SnIh 0(r$51 s . r?.i t. i. il.rir.i

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Role of the Financial System: Financial Markets of the Financial System: Financial Markets
-fole
Financial markets: Primary functions Financial markets: Primary functions
Focilitote the flow of funds: Risk-Return Focilitate the flow of funds: Risk-Return
Ar BsE HSEr
Stock Returns - Top Performers 'EEEE
Returns = -l---l
Po ''ES

- ']' Ei ltE --:'

'" "'!t tE .. :

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 L/10/202

the Financial System: Financlal Markets

"[g]-g.gf ..!9"]e of the Financial System: Financial Markets
Financial markets: Primary functions Financial markets: Primary functions
Facilitote the flow of funds: Risk-Return Focilitate the flow of funds: Timing of the cash t'lows
.

BSE2oo w Steady cash flow over the life of the instrument

cr . Term deposits, receiving fixed rent from a property
Stock Returns- "Losers" ' 'EDd'
LB

.' cB !tr Payment only occurs at the maturity

. Zero-coupon bonds
aa E!.
IE !I' Uneven cash flows
' IE !r! . Dividend payments

Contingent on performance
. lf company is not profitable, it may not pay any dividend in any year

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lg*!-u-of the Financial System: Financial Markets of the Financial System: Financial Markets
Financial markets: Primary functions Financial markets: Primary functions
Ldcilitote the flow of Junds: Liquidity Focilitate the flow of funds: Liquidity
Liquidity: Ease with which the financial instrument can be converted {*:'iK
into cash without losing capital value
lnstruments with higher liquidity are more attractive to risk-averse
nvestors Most active by volume
i

. Can liquidate them at a price that approximates their worth more easily
;
than they can sell illiquid instruments

:,.r...

27 28

Role of the Financial System: Financial Markets

-j9"le of the Financial System: Financial Markets
Financial markets: Primary functions Financial markets: Primary functions
Fdcilitote the flow of funds: Liquidit'. Focilitote the flow of funds
For financial markets to operate efficiently, there is a need to provide
a range of financial instruments to meet the return, risk, timing, and
liquidity preferences of the market participants
. Savers will be able to structure their savings to suit their needs, leading to
Most active by value
increased flow of funds
Increased pool of investment capital can be used by DSUs
(governments and businesses) to increase production, causing
J- :.: ...tr! economy to grow
,ffiffi*i' {rE
rr-.- :xi- h".E*.n + An efficient and stable financial system is a necessary condition to
:ij r-G r* having an advanced economy

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lgl*",ot the Financial System: Financial Markets lglg of the Financial System: Financial Markets
Financial markets: Primary functions Financial markets: Primary functions
Focilitote the flow of t'unds: tconomic units Focilitote the flow of funds: Economic units
Alleconomic units can be classified into one of the following groups: llouseholds
. Households . Receive income in the form of wages
. Eusinesses . Make frequent expenditures for food, clothing, medical needs,
. Governments (local, state, and centre)
entertainment, education, taxes, and housing (rent/mortgage)
Each economic unit operates within a budget constraint imposed by Busi nesses
its total income for the period
' Sell a variety of goods and servjces to households and other businesses
for revenues
. Spend money on paying wages, buying inventory and meeting other
business expenses, and make capital expenditures on new buildings and
p ment
eq ui

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Role of the Financial System: Financial Markets
Financial markets: Primary functions
Focilitote the flow of t'unds: Economic units
Government
. Obtain income by collecting taxes and fees
. Spend on a wide range of services such as health, welfare, education,
police, the fire service, and defense
Role of the Financial System: Financial Markets
Financial markets: Primaryfunctions
Fdcilitote the flow of t'unds: Budget position
Economic unit can have one of the three possible budget positions
. Balanced budget position: lncome and planned expenditures are equal
. Surplus position: lncome for the period exceeds planned expenditure
. Deficit position: Planned expenditure for the period exceeds income

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[-g]e of the Financial System: Financial Markets Role of the Financial System; Financial Markets
Financial markets: Primary functions Financial markets: Primary functions
Focilitote the flow of t'unds: Budget position
f'ocilitote the flow of funds: Budget position
Surplus Spending Unit (SSU):An economic unit whose income in a
period exceeds expenditure Typically business firms and governments are DSUs

Deficit Spending Unit (DSU): An economic unit whose expenditure in llouseholds in general are SSUS
a period exceeds current income
. DSUs include some households, governments, and businesses
The financial system is concerned with transferring money
with it purchasing power
- and
- from SSUs to DSUS
A DSU sells financial claims on itself (liabilities) or sells equity to
obtain needed funds (from SSUs)

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*Ig"!g.of the Financial System: Financial Markets flS-l"q pf the Financial System: Financial Markets
Financial markets: primaryfunctions
Financial markets: primary functions
f:ocilitdte the flow of funds: Budget position
Focilitote the flow of t'unds: Budget position
ln developed
countries in recent
years household I
6tr.rr Gr"r, Ftr."l D"fkft {R, c..) I
savings have been on
I
decline as a result of t
the dramatic growth I
I
in personal debt
levels '\ ,) ::;.1. -

37 38

Role of the Financial System: Financial H/arkeE

*R-ole of the Financialsystem: Financial Markets
Financial markets: Primary functions
Financial markets: Primary functions
Facilitote the flow of funds: Budget position
Focilitoqqjfo flow of funds
20mm0 - Gross fiscal deficit
t2mmo

g
I emm
B e@m

20mm

*sB,.el.ot"..e,.J.."r.r+',*"\r't",.'$9*,"i,.o",."J
-Bank Credlt -Domestic Sources -Foreign Sources

39 40

Role of the Financial System: Financial Markets

Financial markets: !rl' !r, i ;t,,,,..:i,.i.i l).,1,,. _.,,1.)
Financial markets: Primary functions
Focilitate the flow of t'unds Foc.ilitlgtq !!1e flow of t'unds
llousehold Debt to GDp ,

Household Debt to
GDP (Percent)

..-..i.,._._

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Role of the Financial System: Financial Markets Role of the Financial System: Financial Markets
Financial markets: Primary functions Financial markets: Primaryfunctions
focilitote the flow of t'unds: Budget position Focilitote the flow of t'unds: Finoncial cloims
40
f'low to transfer the SSU's excess purchasing power to the DSUs?
35

Financial claims are issued by DSUs and purchased by SSUs

2t
. Claims against someone else's money at a future date

To the DSU, a financial claim is a liability and the interest payments

are the penalty for consuming before income is earned
'to the SSU,
the financial claim is an asset and the interest earned is
the reward for postponing consumption
q$BEg€ g€HEEEEaHiiHEif EE

43 44

Financial Markets: Flow of Funds Role of the Financial System: Financial Markets
Financial markets: Primary functions
Financial markets: Primary functions
Focilitote the flow of lunds: Finonciol cloims
Focilitote the flow of t'unds: Financiol cloims
Once a financial claim is outstanding, the lender (SSU) may hold the
Balance Sheet: claim until it matures
Assets = [.iabllities + Equity Alternatively, the SSU may sell the financial claim to someone else
before it matures
Ba nk: The DSU continues to have use of the funds even though the lender
is now a different party
Sally's deposit: Liability
Caf6 loan: Asset

45 46

lg"lg-of the Financial System: Financial Markets !g19 of the Financial System: Financial Markets
Financial markets: Primary functions Financial markets: Primary functions
Focilitote the flow of t'unds: Finoncial cloims Focilitote the flow of t'unds: Finonciol claims
Financial claims are sourced from either debt or equity funds Debt funds are supplied in the form of a loan (borrowing)
Shares (equity): Dividends Can be classified into short- or long-term facilities
;tt
'',1':ll
. Short-term loans are referred to as money
' Long-term loans are referred to as capital

Suppliers of loans face credit risk

Bonds (debt): Coupon (interest) payments . Risk that the borrower will not pay back all or part of the interest or
principal as specified in the loan agreement
. ln return for exposure to credit risk, the lender is rewarded with interest
income

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Role of the Financial System: Financial Markets

!gl9 of the Financial System: Financial Markets
Financial markets: Primary functions Financial markets: Primary functions
Focilitote the flow of funds: Finoncial cloims Focilitote the flow oJ t'unds: Finonciol claims
Providing equity funds jnvolves the acquisitjon of an ownership The ability to resell financial claims is important because it allows
share of a business
. SSUs to purchase financiai claims with maturities that do not exactly
Longer term: Referred to as capital investment
match their investment horizon
Equity investors face investment risk: possibility that the expected
return will not be realized
' lnvestors are compensated with dividend payments and capital growth for
bearing investment risk
. The size of these returns is largely dependent
on the performance of the
business and so is less certain than returns on debt funds, which are
usually specified in the debt contract

49 50

Role of the Financial System: Financial Markets Role of the Financial System: Financial Markets
Financial markets: Primary functions Financial markets: Primary functions
Focilitate the flow of t'unds: Finonciol cloims Focilitote the flow of t'unds: Finonciol cloims
lf an SSU purchases a financial claim with maturity longer than the A wide variety of financial claims trade in the financial markets, all
planned investment period, the claim can be resold toinother SSU
designed to meet the preferences of both SSUs and DSUs
at the appropriate time . Risk of default
. Suppose your investment horizon is five years _ purchase . Maturity
a 10_year bond
or purchase shares, and sell them after five years . Liquidity
. Timing of cash flows
Likewise, an SSU can purchase a financial claim with maturity shorter . Marketability (ease with which a financial claim can be resold)
than the investment horizon . Tax treatment, and
. Suppose your investment horizon is five years - purchase . Other special features such as options and convertibility
a 2-year bond into another type
and then purchase another 3-year bond of financial claim

51 52

Role of the Financial System: Financial Markets of the Financial System: Financial Markets
_ Lo]-e
Settl e me nt of tro nsdcti o ns Settl e me nt of tronso cti on s
The financial system permits the flow of funds through an economy Many transactions in the payments system are settled immediately
This occurs through millions of transactions that occur each day . For example, when a person uses cash to purchase a book, the funds are
provided to the retailer immediately and the buyer receives the book
among various market participants
Each of these transactions generates a transfer of funds that must be
lligh-valued transactions are settled after the terms of the
settled (or completed) within the system transaction have been agreed
. Seller has provided the item purchased and received
. For example, when one purchases a house, the settlement occurs on the
the agreed amount settlement date, which can be 30 or 60 days after the contract is signed
of funds in return
(when terms are agreed)
A key roJe of the financial system is to provide an efficient payment
Many transactions jn the securities markets are settled on a f+ n
system for those settlements to occur
basis, which is n business days after the trade was agreed

53 54
 L/LO/2o2

j9.le of the Financial System: Financial Markets

[q].. gf the Financial System: Financial Ma rkets
Financial markets: Primary f unctions
Financial markets: Primary functions
Settle ment of tr d n so ctions
Settl e me nt of tro n socti o ns
There are separate settlement systems for the small-value retail
transactions and large-value wholesale transactions
National Electronic Fund Transfer (NEFT): Nation-wide centralised
payment system owned and operated by the RBI
Real Time Gross Settlement (RTGS): System where there is continuous
and real{ime settlement of fund,transfers, individuallV on a transaction_
by-transaction basis (without netting)
. 'Real Ttme' means the processing ofinstructions at the time thev are receivecj
. 'Gross SetUement'
means thdt the settlement of funds transfer rnstructions
occurs individually

lBmt

55 56

*[o]-e of the Financial System: Financial Markets lqlq of the Financial System: Ma rkets
Financial markets: Primary functions
Settl e m e nt of tro nsocti o ns
UPI:System that powers multiple bank accounts into a single mobile
application, merging several banking features, seamless fu"nd routing
and merchant payments into one hood
IMPS: Provides robust and real time fund transfer which offers an
instant, 24X7, interbank electronic fund transfer service that could
be accessed on multiple channels like Mobile, Internet, ATM, SMS
PPls: lssu-ed by an entity for facilitating the purchase of goods and
services from that entity only and do not permit cash withdrawal,
cannot be used for payment or settlement for third party services
(not a payment system and therefore, not regulated by tiBl)

57 58

Ig.l5-qf the Financial System: Financial Markets *t,ol-g of the Financial System: Financial Ma rkets
Financial markets: Primary functions
Settl e me nt of tro n so cti o ns
UPI (Rlls): Unified Pavments

. ppti prepaid payment tnstruments

I
E tMpS: tmmedrare paymenrServire
NEFT: Nationat
Iran*er
fle.ronic Fund

E .
. Debit Cards

@ Credit Carde
qTGS: Real lrmeGrors SFrrtemenr

tilii @ I N€FTI
5VStem
- '. papeFbased/cash payments

59 60

t
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l_o-Lg of the Financial System: Financial Markets Rol.e of the Financial System: Financial Markets
Financial markets: Primary functions Financial markets: Primary functions
uPl (RHs): unified Pavments
settrement ol tronsoctions Settl e m e nt of tro nsqcti on s
PPI: Prepaid Payment
"'@- lnstruments
IMPS: lmmediate Payment
November 2022 November 2021
No olTransacllons (ln lakh)
November 2020 Nov€mber 2019 Nov€mber 2015
. Service N EFI 4,338 3,394 2,734 2.,1-95 998
@ NEFI National Electronic RTG5 206 156 138 134 76
tund lransler 79,1,24 45,046 24,L98 13,623
Mobile 405
lrups Oebit Cards
I :redil Cards - AIM 7 5 5 8 5
Credit Cards
m;it RTGSr Real Time Gross
1,3 20 2.,O1,7 1,663 7,425 660
l arpdli 5,567 5,664
I
Settlement System 5,868 6,240 6,746
'ffil lPPrl
Paper-based/cash payments 1,792 3,404 3,190 4,236 999

6t 62

_lg.1g ot the Financial System: Financial Markets Role of the Financial System: Financlal Markets
Financial markets: Primary functions Financial markets: Primary functions
Settl e me nt of t ro n sa cti o ns Settle me nt of trd n socti on s
Amount ol Transactions (in crore)
The payment system is a critical part of the financial system
Novetrrber 2022 Novenrber 2021 November 2020 November 2019 November 2015 . Mechanism by which funds are actually transferred to complete
\EFT 27,30,a7a 23,74,490 22,18,253 71 ,34,657 6,37,076 transactions
tTGS L22,91,750 98,63,113 79,a1,655 86,79,806 53,89,603
19,92,O7 2 13,06.948 8,20,024 4,7L 195 33.47 An effective payment system is characterized by its efficiency in
:redit Cards -ATM 216 237 381 258 terms of
fedit Cards - POS 46,296 49.277 6 2,3 50 60,130 20,169 . Speed, cost, and stability
)ebit Cards AIM 2,63,4a3 2,77,O75 2,17,557 2,8L,S70 2.15,114 . Financial strength of the financial institutions (including the central bank)
66,602 67,357 57,590 14.899 . Settlement mechanism for transferring funds among them

63 64

*[p-F qf the Financial System: Financial Markets tqlg of the Financial System: Financial Markets
Financial markets: Primary functions Financial markets: Primary functions
P rov i si o n of i nform otion Prov i si on of i nformoti on
A further role of an efficient financial market is to provide sufficient
economic and financial information to enable particlpants to make
[.oan - Sally for her studies
. Why will bank lend Rs 10 lakhs to Sally?
informed investment decisions . Which bank will Sally choose to deposit Rs 7 lakhs?
. Participants:5ally, bank, cafd owner . Why will bank Iend funds to caf6 owner to expand his business
. lnvestment decisions: Savings account, term deposit, shares, bonds
etc
lnsurance - Car, health, life insurance
For the markets to be efficient, this information needs to be
available in a timely fashion to all market participants so that all have Sha res/bonds?
equal opportunity to make informed decisions Decisions in relation to investments, loans, savings, insurance, and
other financial products require information to facilitate them

65 66
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Role of the Financial System: Financial Markets the Financial System: Financial Ma rkets
B_ol".gf
Financial nrarkets: Primary functions Financial markets: Primary functions
P rov i sio n of i nformoti on
P rov i si o n of i nformati o n
Credit rating agencies play an important role in the provision of
rntormation on companies, govcrnments, and other organizatrons, ,lame of the rating agency r'linimum investment
and the financial instruments that they use :rade credit mtins
he Credit Rating lnformation Se.vices of tndia Limited {CRtStL)
'Ihey 1, FA- {FA Minus)
typically publish informed assessments about the financial S&P)
standing of securities and institutions using a standard scale 2 :RA Limited (Moody's) MA- (MA Minus)
. For exmple, S&P credit ratings AAA, AA, A, BBB (investment grade) :redit Analysis and Research Limited (CARE)
and CARE BBB (FD)
BB, B, CCC, CC, C, D (speculative or noninvestment grade)
4 :itch RatinBs lndia Private Limited tA- (indXFD)
The,three big rating agencies are Standard and poor,s, Moody,s, and 5 k Ratings lndia Private Limited (Brickwork) BWR FBBB
Fitch Ratings 6 \cuite Ratings and Research Limited ACUITE A
7 s Valuation and RatinB Private Limited (lVRpL) IVR BBB

67 68

Role of the Financial System: Financial Markets of the Financial System: Financial Markets
-l9le
Financial markets: Primary functions Financial markets: Primary functions
*"""".:",111:i::i:,:s.dLinlited
provision of informotion P rovi s i o n of i nformati o n
R.1n! Ai[on
T.Dr8.ilrt to( Frcdr,cs f,.il.d (, nrooCCr,xr C.'::ir/1.n,,. 511r,;l.ir.i
Ion0 ttrm (rtns CirstL AAA,sr.{nd lntrrn,rrdl
lri*ilirr
er.1tt00 cro,! Xo. Cohvril'U[' Ocl.hrftr CnrSI AAISr'L$ lR.r,irr:di
Rr.ll@! CroG tter Crilveilrh[ DrLpnh"rr CRISIL AAA)SIhli iQrrlltn].i1
Rr t0m Cror. llon Cor!e{rbtr Oph.nUrs CRISIL A&:SIr[ts IArr,tilkd)
4r.20$ C,o,+ xo C.Av.il1rr! 0aU{nnnes
h!.10m! Crnr lto. Cnnvrdihti OpLrn(nt CirSlt AiA 5t.r!ti lR.itnrn.dt
qt 10&0cr6rr &il clns.triur o.b4{&rpr cFrslt AAt,s!rblP tQ..rililn ?dt
R!.1@) C.r/c No. Cqrv.nibt. tub.iail.1 CRTSTL AAA'StJblr (4.Jfi nd.d)
ti *tc..,. iloncoiv.ilb:. tutxnt!rit CFr!rL AA{sribtr 1R(irti'nEd)
Rt 1!@ Crorr Cdn^{r.)il P.rFr carstL A1r lFcrilnnFdl

69 70

*sl.lg,qt the Financial System: Financial Markets 3g]." of the Financial System: Financial Markets
P rOvi Sio n Of i nform oti on source, hnp5://www.trtan,oro,s.com/investor'/c,edi!,arin8s/

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Role of the Financial System: Financial Markets

!9!e of the [:inancial System: Financial Markets
Financial markets: Primary functions Financial markets: Primary functions
Provision of informotion: Criticism of roting agencies Transfer ond management of risk
Conflict of interest: lnvolved in the management of companies they Risk relates to uncertainty and the chance of an unexpected
are rating and being paid by outcome being achieved
Suggested errors in ratings given to structured debt products which A key role of the financial system is to allow for financial risk to be
have subsequently been downgraded or even defaulted managed and/or transferred to other parties
. For example, through derivative and insurance products
Either too slow or reluctant to downgrade organizations
. For example, Enron was rated AAA a week prior to flling for
bankruptcy
. Bad loans from flawed assessments of investments by established
iatings
agencies was a major cause of the global financial crisis

73 74

l':>-!" gf the Financial System: Financial Markets Role of the Financial System: Financial Markets
Financial markets: Primary functions
Financial markets: Primary functions
Deoling with incentive problems
Deoling with incentive problems
The fi.nancial system also has a role in mitigating incentive issues that
arise in financial contracts Information asymmetry occurs when the contracting parties do not
have equal access to relevant information and therefore one party is
Exa m pl es: at an advantage
lnformation asymmetry
Agency problems
Moral hazard
Adverse selection
Undermine the financial system's processes and create risk for
parties to a financial contract

75 76

Role of the Financial System: Financial Markets RoJe of the Financial System: Financial Markets
Financial markets: Primary functions Financial markets: Primary functions
For example, a prospective borrower is likely to know more about his Deoling with incentive problems
ability to repay, and intended use of the borrowed funds, than the
lender Financial intermediaries apply standardized credit procedures to
mitigate this issue
Outcome: Bank, when presented with a choice between funding
several loans, does not select the best loan as they do not have all Regulations impose disclosure rules on financial organizations to
the relevant information available to them provide all parties with adequate information

9 Adverse selection: A market process where a less than optimal

outcome is achieved due to parties having asymmetric information

77 78
 1.lLo/202

Role of the Financial System: Financial Markets

Iglg. of the Financial System: Financial Markets
Financial markets: primary functions Financial markets: Primary f unctions
Deoling with incentive problems Deoling with incentive problems
Moral hazard is the risk that one party to a contract can change their
*has The principal-agent relationship is created when there is a separation
behavior to the detriment of the other party once a contract
between ownership (the principal) and control (the agent) of an asset
been concluded . Shareholders of a company employ managers to act on their behalf
This is a key issue for insurance companies, where there is a risk that
once an asset is insured, the covered party may not be as careful to Agency Problems: lnterests of the principals and agents are not aligned
. Managers may want to maximize their chances of employment elsewhere and
protect the asset as they otherwise would be
. Managed through to improve their yearly bonus

' Continuous monitoring (multiple claims cause insuraoce premiums to go up) The financial system manages this problem through various devices that
. Sharing of information between organizations (such as with credit record data) aliBn the interest of principals and agents, as well as implementing an
. Requiring continuous disclosure of material information by companies
effective regulatory environment (board, SEBI, RBI)

79 80

Tr.ansferring Funds from SSUs to DSUs Transferring Funds from SSUs to DSUs
'Ihe purpose
of the financial system is to transfer funds from SSUs to Direct Financing
DSUs as efficiently as possible
In direct financing, DSUs and SSUs exchange money and financial
The job of bringing DSUs and SSUs together can be done by direct claims directly
financing or by indirect financing (financial intermediation)
DSUs issue financial claims on themselves and sell them directly to
The goal is to bring the parties together at the least possible cost and SSUs for money
with the Ieast inconvenience
The SSUs hold the financial claims in their portfolios as interest-
Sally and other depositors + Banks + Cafe bearing assets
The financial claims are bought and sold in financial markets

81 82

_Iqnsferring Funds from SSUs to DSUs

-_Tra-nsferring
Funds from SSUs to DSUs
Direct Financing Direct Financing
The transactions appear as changes in the balance sheets (asset and The claims issued by the DSU are called direct claims and are
liability holdings) of the two parties typically sold in direct credit markets such as the money or capital
DSU ma rkets
Assets Liabilities Liabilities
- Money to
Direct financing gives SSUs an outlet for their savings, which
+ Money to DSU + Direct provides an expected return, and DSUs no longer need to postpone
D5U claims sold to current consumption or forgo promising investment opportunities
DSU for lack of funds
+ Direct
claims bought .r Direct credit markets increase the efficiency of the financial
from DSU system

83 84

1,
 t/1,0/202

.Ia.nsferring Funds from SSUs to DSUs Funds from SSUs to DSUs

Direct Financing -Iransferring
Direct Financing
Upper portion illustrates the flow of funds from SSUS to DSUS by way Privote plocements
of direct financing in financial markets
the simplest method of transferring funds between SSUs and DSUs
tqEql!1rcEgl is a private placement
Suppliers of funds (SSUs) Demanders of funds {DSUs) DSU, such as a corporation, sells an entire security issue to a single
'Households . Households institutional investor or small group of investors
. Businesses . Businesses
. Governments . Governments The advantage of a private placement is the speed with which funds
can be committed and the low transaction cost of bringing the
securities to market
Financial
An investment bank usually assists corporates in private placements
lntermediaries
and charges a fee for helping to design and place the securities

85 86

Transferring Funds from SSUs to DSUs

*]_qn;ierring Funds from SSUs ro DSUs
Direct Financing
Direct Financing
lnvestment bonks
Brokers ond deolers
Another direct method of bringing financial claims to market is with the
services of an investment banker, who helps DSUs market newly created Once financial claims have been issued, they may be resold to other
financial claims, often called initial public;fferings (tpOs) i nvestors

Underwriting: Investment bank purchases an entire issue of stocks or
bonds from the DSU at a guaranteed price and then resells the securities
individually to investors at a higher price
. Llnderwriting Spread: Difference between the purchase and sale price
lnvestment banks provide other services to their clients such as helping
prepare the prospectus, selecting the sale date, and providing general-
financial advice to the issuer
Brokers and dealers aid in the process of bringing buyers and sellers
together
Brokers do not actually buy or sell securities; they only execute their
clients' transactions at the best possible price
Brokers bring SSUs and DSUs together and are compensated for their
services with a commission

87 88

Jransferring Funds from SSUs to DSUs: Direct Financing Transferrlng Funds from SSUs to DSUs
Direct Financing
lndirect Financing
Brokers and dealers
Denominations of the securities sold in direct credit markets are very
Dealers 'make markets' for securities large so few consumers can transact in these markets
Carry an inventory of securities from which they stand ready to buy or
DSUS must find SSUs that want direct claims with precisely the
sell securities at the quoted price
. Dealers make profits by selling from their inventory characteristics they can and will sell
. On average, sell securities for a higher price (ask piice) than they paid
for them
(bid price)
. Bid-Ask Spread: Difference between the bid and ask price represents the
dealer's gross profit

Most dealers also function as brokers and typically specialize in a

particular type of market such as the commercial paler, bond, or equity
sha res

89 90

t
 L/1.0/202

Transferring Funds from SSUs to DSUs to

, Tiansferring [:unds f rom SSUs DSUs
lndirect Financing Lower portion shows that because financial intermediaries are
Sally needs the proceeds from her student loan to pay for tuition and involved the flow of funds from SSUs to DSUs is indirect
books at the beginning of the second semester
Ioi*t rinunJnil
She does not want to invest her funds in a 30-year corporate bond
Suppliers of funds (SSUs) Demanders of funds (DSUs)
because it has a longer maturity than she needs . Households
'llouseholds
'Businesses . Businesses
Corporate bond and stocks are risky . Governments . Governments

Sally may not want to risk having the price of the bonds/stocks go
down, jeopardizing her ability to pay her second year tuition fees
Term deposit gives Sally a safe place to store her money until she
needs it and at the same time earn interest

91 92

Transferring Funds from SSUs to DSUs

fransferring Funds from SSUs to DSUs
Financial intermediation Financial intermediation
Financial intermediaries transform financial claims in ways that make [:or direct financing to take place, the DSU must be willing to issue a
them more attractive to the investor secunty with a denomination, maturity, and other security
Financial intermediaries include commercial banks, life insurance characteristics that match the SSU's desires exactly
companies, pension funds, to name a few Unless both the SSU and DSU are satisfied simultaneously, the
These and other financial intermediaries emerged because of transfer of money will not take place
inefficiencies found in direct financing

93 94

*Transferring Funds from SSUs to DSUs Jransferring Funds from SSUs to DSUs
Financial intermediation ssu lntermediary
Financial DSU

Financial intermediaries intervene between the borrower (DSU) and Assets Liabilities Assets Liabilities Assets Liabilities
the lender (SSU) - Money to + Money + lndirect + l\4oney + Direct
fi nanci a I from 55U claim to 55U from claim to
Financial intermediation: Financial intermediaries (or financial intermed iary financial financial
institutions) purchase direct claims with one set of characteristics
intermediary
(e.9., term to maturity, denomination) from DSUs and transform
them into indirect claims with a different set of characteristics, which - Money to
they sell to the SSU DSU
+ lndirect
claims from + Di rect
financial claim from
intermediary DSU

95 96
 L/1,0/202

Tlansferring Funds from SSUs to DSUs

*[g_11fe-rring Funds from SSUs to DSUs
sSU lntermediary
Financial DSU Financial intermediation
Assets Liabilities Assets Liabilities Assets Liabilities
- Money to I Money lndirect + Money + Direct Financial intermediaries operate to make a profit and they buy and
l+ sell specialized financial products to do so
financial trom SSU claim to 55U from I claim to
intermediary Source of funds 11nrn.1r1 financial They buy financial claims (held as assets of the intermediary), such
intermediary intermediary as business loans, consumer Ioans, corporate bonds, corporate
- Money to common stock and government bonds, from DSUs
DSU 'Ihese financial
claims have characteristics designed to meet the
+ lndirect
needs of particular DSUs
claims from + Direct
fi nancial claim from
DSU
I lsc r:1' lLrritls

97 98

Transferring Funds from SSUs to DSUs 'Iransferring Funds from

. SSUs to DSUs: Financial Intermediation
Financial intermediation
Financial intermediaries finance the purchase of these financial
claims by selling financial claims on themselves (held as liabilities of
the intermediary), such as cheque accounts, savings accounts, life
insurance policies, and managed funds to SSUs
These financial claims have characteristics that are attractive to SSUs
Financial intermediation
To earn profits, financial intermediaries buy financial claims from
DSUs whenever the income generated by the financial claim is
expected to cover all of their borrowing and production costs
In the Sally example, the local bank charge the caf6 owner g percent
for the business loan, and the bank's cost of funds for deposits is 4
percent
lhe bank's gross interest margin is 4 percent, from which the bank
has to cover its cost of manufacturing the loan, its overhead
expenses and the risk of not getting paid back (credit risk)

99 100

Jra.nsferring Fu nds f rom SSUs to DSUs Ti-ansferring Funds from SSUs to DSUs
."
Financial intermediation Financial intermediation
Financial intermediaries can achieve economies of scale because of Financial intermediaries may be able to obtain important
their specialization information about a borrower's financial condition because they
. Handle many transactions therefore they are able to spread out their have a history of exercising discretion with this type of information
fixed costs
They may be able to reduce the problem of unreliable information
They can reduce the transaction costs involved in searching for credit
because of their intimate knowledge of the borrower,s operations,
information
. A consumer who wishes to lend directly can also search for information, personal history, and character
but usually at a higher cost

101 1.02

1
 Ll1.0/202

.Jransferring Funds from SSUs to DSUs *Irensferring Funds from SSUs to DSUs
Financial intermediation Financial intermediation
f:inancial intermediaries are often able to produce financial services I nte rm e d i oti o n se rvice s
at a lower cost than individual consumers
ln 'transforming' direct financial claims into indirect ones, financial
Competition among financial intermediaries tends to force interest intermediaries perform five basic services:
rates to the lowest level compatible with their cost structures
Denomination divisibility
A high rate of economlc growth requires a substantial amount of
buslness expenditure (investment) Currency transformation

The lower interest rates are, the more willing businesses are to make Maturity flexibility
expenditures on real investments Credit risk diversification
t-iquidity

103 104

Transferring Funds from SSUS to DSUS: Financial Intermediation Transferring Funds from SSUs to DSUs: Financial Jnterntediatron
Financial intermediation Financial intermediation
I nte rmedi oti o n se rvi ces : De nomi nati on d ivi s i bi I i ty n
I nte rme d i oti o se rvi ce s : Cu rre n cy trdnst'o rm otion
Financial intermediaries are able to produce a wide range of Many companies export goods and services to other countries, but
denominations from one rupee to many millions few individuals are willing to finance the overseas activities of these
They can do this by pooling the funds of many individuals and companies by buying direct financial claims denominated in a
investing them in direct securities of varying sizes foreign currency

Of particular importance is their acceptance of deposits from Financial intermediaries help to finance the global expansion of
individuals who typically do not have money balances large enough domestic companies by buying financial claims denominated in one
to engage in the wholesale transactions found in direct financial currency and selling financial claims denominated in other
ma rkets cu rre nc i es

105 106

Transferring Funds from SSUs to DSUs: Financial Intermediation Transferring Funds from SSUS to DSUs: Financial Intermedjation
Financial intermediation Financial intermediation
In te rme d i oti on se rv ices : M ot u ri ty t'l exi b ity nte r me d i oti n rvi ce s : Cred it ri sk
iI I o se d ive rsifi c otion
Financial intermediaries are able to create securities with a wide By purchasint a wide variety of securities, financial intermediaries
range of maturities from one day to more than 30 years are able to spread risk
. For example, lending funds to individuals and businesses
ln this way, they are able to buy direct claims issued by DSUs and
issue indirect securities with precisely the maturities desired by SSUs lf the securities purchased are less than perfectly correlated with
each other, the intermediary is able to reduce the fluctuation in the
value of their portfolios

107 108
 t/Lo/202

Transferring Funds from SSUs to DSUs: Financial lntermediation Transferring Funds from SSUs to DSUs: Financial lntermediation
Financial intermediation Financial intermediation
I nte rme di otio n se rvi ce s: Li q u i d ity Financial intermediaries tailor the characteristics of the indirect
For most consumers, the timing of revenues and expenses rarely securities they issue to the desires of SSUS
coi ncides
They engage in one or more distinct types of intermediation:
Because of this, most economic units prefer to hold some assets that denomination, currency, risk, maturity, and liquidity
have low transaction costs associated with converting them into
money They provide these and other services to earn a profit
Many of the financial commodities produced by intermediaries are SSUs and DSUs use financial intermediation services as long as the
highly liquid cost of doing so is less than providing the services for themselves
. For.example, a savings account permits consumers to purchase an asset
with minimal transaction cost d i rectly

109 L10

Transferring Funds from SSUs to DSUs: Financial Intermediation

..*lypes of Financial lntermediaries
Financial intermediation Many types of financial intermediaries coexist in an economy
SSUs and DSUs choice between the direct and the intermediation Ihey all have one function in common: they purchase financial
market depends on which market best meets their needs claims with one set of characteristics from DSUs and sell financial
When transactions involve small amounts (retailtransactions), the claims with different characteristics to SSus
intermediation market is more cost effective lndian financial system consists of the RBl, commercial banks,
Economic units that deal in large amounts (wholesale transactions) nonbanking financial companies, insurance companies etc
switch back and forth between the two markets, selecting the
market that offers the most favorable interest rate
. For example, many large businesses take out loans from commercial
banks (an intermediation transaction), and also raise money by selling
commercial paper in the direct credit market

L1.1 1.1.2

of Fina ncia I ntermed ries

*"ly.p"r of Financial lntermediaries
*Ly-p-gt I ia

N Assets (Amount in Rs 1OOO crores) Local Area Banks: lurisdiction over two or three contiguous districts,
Private Sector Banks introduced to enable the mobilization of rural savingiand make them
7,371,.7
available for investments in the local areas
Public Sector Banks 72 1,2,706.7
Small Finance Banksi To further financial inclusion by (i) provision of
Local Area Banks 3 1.3 savings vehicles primarily to unserved and underserved sections of the
Small Finance Banks t2 203.1, population, and (ii) supply of credit to small business units; small and
Payment Banks 6
marginalfarmers; micro and small industries; and other unorganised
1,7.7
sector entities, through high technology-low cost operations
Regional Rural Banks 43 705.4 . Coastal Local Area Bank Ltd, Krishna Bhima Samruddhi LAB Ltd
Foreign Banks 43 1,368.5 Payments Banks: fo further financial inclusion by providing (i) small
"Financial lnstitutions" 4 1,,221.2 savings accounts and (ii) payments/remittance services to higrant labour
workforce, low income households, small businesses, other unorganised
State Cooperative banks 34 377.3 sector entities and other users (example, Airtel, paytm, Jio payments
Bank Ltd)

tt3 L14
 t/1.0/202

lypes of Financial Intermediaries Fi n a ncia I I nte rmed ia ries

*Jy-ge.1of
Regional Rural Banks: Priority sector lending (Agriculture, MSME, lnsuronce companies
education, housing, social infrastructure, renewable energy, others)
Private Sector Public Sector
State Cooperative Banks: Mandated to ensure flow of credit to the
N Assets N Assets
agriculture sector (some of them regulated by RBI jointly with the (Rs Crore) (Rs Crore)
state/centre government)
Life lnsurers 23 1 1,357.5 1 38,117.6
General lnsurers 20 2,084.8 6 2,061.3
Stand-alone health insurers 5 178.5 0 0
Reinsurers 1,1, 289.7 1 1-,346.6
Tota I 59 13,910 8 47,525.4

11s 116

Types of Financial lntermediaries of Financial lntermediarles

--ly,pgt
Fi n o nci o I in stituti on s Non-Banking Financial Companies
National Bank for Agriculture and Rural Development (NABARD) are doing functions similar
NBFCs to banks then what is difference
Export-lmport Bank of India between banks and NBFCs?

National l-.lousing bank NBFCs lend and make investments and hence their activities are akin
to that of banks; however there are a few differences as given below:
Small lndustries Development Bank of lndia (SlDBl) . cannot accept demand deposits
NBFC
. do not form part of the payment and settlement system and
NBFCS
cannot issue cheques drawn on itself
. Deposit insurance facility of Deposit lnsurance and Credit Guarantee
Corporation is not available to depositors of NBFCs, unlike in case of banks

1.17 118

of Financial lntermediaries
."_IypSr Jpe_r of Financial lntermediaries
Non-Banking Financial Companies
NBFCs are categorized in terms of the type of liabiljties into
(a) Deposit and Non Deposit accepting NBFCs
(b) Non-Deposit taking NBFCs are further categorized by their size
(a) Systematically important (asset size is of I 500 cr or more) and
(b) Other non-deposit holding companies (NBFC-NDSI and NBFC-ND)

(c) Kind of activity they conduct

119 120

2
 1/1.0/202

.J-y,p.t of Financial Intermediaries: NBFC *.]-y g-es

Non-Banking Financial Companies
NBFC-Factors: Non-deposit taking NBFC engaged in the principal
business of factoring
. Factoring Business: Business of acquisition of receivables
Infrastructure Debt Fund (lDF): To facilitate the flow of long_term
debt into infrastructure projects, raise resources through issue of
bonds of minimum S-year maturity
lnfrastructure Finance Company (lFC): Deploys at least 75 per cent of
its total assets in infrastructure loans and has a minimum Net Owned
Funds of { 300 crore
of
[:ina ncia I I ntermediaries
Non-Banking Financial Companies
Micro Finance Institution (NBFC-MFl): Non-deposit taking NBFC
having not less than 85% of its assets in the nature of qualifying
assets (for example, loans disbursed to a borrower with a rural
household annual income not exceeding < 1,00,000 or urban and
semi-urban household income not exceeding { 1,60,000)
NBFC- Non-Operative Financial tlolding Company (NOFtlc):
Promoter/promoter groups willbe permitted to set up a new bank
. llold the bank as well as all other financial services contpanies regulated
by RBI or other financial sector regulators

1.21. 122

-*I.y.qur
of Fina ncia I I ntermed ia ries of Financial lntermediaries
"*J-Vpgt
Non-Banking Financial Companies Non-Banking Financial Companies
Asset Finance Company (AFC): Financing real/physical assets Systemically lmportant Core Investment Company (CIC-ND-Sl): llolds
supporting economic activity and income arising therefrom is not at least 90% of its total assets in the form of investment in equity
less than 60% of its total assets and total income respectively
shares, preference shares, debt or loans in group companies
lnvestment Company (lC): Acquisition of securities Mortgage Guarantee Companles (MGC) - At least 90% of the
Loan Company (t.C): Providing of finance whether by making loans or business turnover is mortgage guarantee business or at least 90% of
advances or otherwise for any activity other than its own but does the gross income is from mortgage guarantee business and net
not include an Asset Finance Company owned fund is { 100 crore

Ihe above three categories were merged into a new category called
NBFC - lnvestment and Credit Company (NBFC-lCC) in 2019

1.23 1.24

lnternational Orga n izations I n.ternational Orga n izations

lmportant international organizations play a significant role in the Bonk for lnternotionol Settlements (BlS)
financial markets
llas a mandate to encourage international monetary and financial
Bank for lnternational Settlements (BtS) cooperation
World Bank Operates as a banker for the central banks of countries around the
lnternational Monetary Fund (lMF) world
Asian Development Bank (ADB) Plays an important role in helping to maintain the stability of the
global financial system

1_25 126
 L/1,0/202

International Organizations rnational Orga n izations

*l =nte
The World Bonk I nte rnoti o no I Mon eto ry Fu nd
Not a bank per se rather an agency of the United Nations that aims IMF established under the United Nations:
to reduce poverty and improve living standards in developing
To promote international monetary cooperation
nations
lb facilitate the expansion and balanced growth of international
It has 185 member nations that jointly finance and allocate the trade
resources of the World Bank
To promote exchange stability
The World Bank has lent more than USD415 trillion on various
programs across the globe since 1990 To assist in the establishment of a multilateral system of payments in
respect of current transactions between members
Plays a major role in the global community
To make general resources of the Fund temporarily available to the
member nations

127 L28

lnternational Organizations
_-iy-p"f of Financial Markets
Asion Development Bonk (ADB) [:inancial intermediaries buy the financial claims of others and sell
Multilateral development bank that aims to reduce poverty and their own claims in the flnancial markets
improve living conditions and quality of life in the Asla-pacific region There are many different types of financial claims issued in the
primary markets by financial intermediaries and other economic
units such as the federal government and large corporations

129 130

*IV_p"Sl of Financial Markets .--l-ype! of Financial Markets

Money and capital markets Money ond copitol morkets
Primary and secondary markets Financial markets are sorted into money and capital markets on the
Organized and over-the-counter markets basis of the term to maturity of a given financial claim

Derivative ma rkets Securities trade in these two markets based on the requirements of
the users and providers of the funds
Foreign exchange markets
A wholesale short term to maturity claim (less than 12 months to
maturity) is classified as a money-market transaction

131 1"32

2
 t/L0/202

Jyp"r of Financial Markets _"ly.pur of Financial Markets

Money markets Money markets
Consist of a collection of markets, each trading a distinctly different Financial institutions adjust their liquidity position by borrowing,
financial instrument lending or investing
. Wholesale market for financial claims that have characteristics
very
similar to money Central banks conduct monetary policy (controlling the level of funds
. Short maturities, highly liquid (active secondary markets), and low default risk in the market and the level of interest rates)
. Examplest Treasury notes, commercial paper
. No formal organized exchange similar to equity markets (85E, NSE) Businesses, governments and sometimes, individuals borrow or lend
. Dealers and brokers specialize in one or more money market instruments funds

133 134

Iyp..r of Financial Markets lypes of Financial Markets

Copitol morkets
Capital-market transactions match savings to the requirements of
individuals, businesses and governments for investments that are
longer term than those offered in the money markets
Owners of machine, factory, apartments, office buildings,
warehouses, and other tangible assets hope to earn a stream of
future income by using their resources to make products or provide
services directly to consumers or to other businesses
. These assets are called capital goods; they are the stock of
assets used in
production
Capitol morkets
Capital goods are financed with stocl( or long-term debt instruments
. Example: Shares, corporate bonds, government bonds
Compared with money,market instruments, capital market
instruments are less marketable, default risk levels vary widely
between issuers, and have longer maturities
. A financial instrument is classified as a capital-market instrument if jt
has
an original term to maturity of one year or more
Financial institutions are the connecting link between the short-term
money markets and the longer-term capital markets
. Typically borrow short term and invest in longer-term capital projects,
either indirectly through business loans or directly into capital-market
instruments

135 136

*Iy_pgt of Fina ncia I Ma rkets *lJp."s of Financial Markets

Primory ond secondary morkets
Financial claims are initially sold by DSUs in primary financial
markets, market in which financial claims are first sold as new issues
. Example: tnfosys raising funds through the sale of new stock or bonds
Secondary market: A financial market in which participants buy or
sell previously issued financial claims
. Securities are sold only once in the primary markets, all subsequent
transactions take place in the secondary markets
. Secondary markets provide Iiquidity for investors who own primary
claims
O rga n ize d o n d ove r-the-cou nte r md rkets
Once issued, a financial claim (security) can be traded in the
secondary market on an organized security exchange (such as NSE)
. Only members of the exchange may use the facilities, and only securities
listed on the exchange may be traded
Alternatively, financial claims can also trade 'over-the-counter,
through a dealer/broker

137 138

2
 t/1,0/202

*Iq"r of Financial Markets

*-Lypu: of Financial Markets
Derivative morkets
A futures market is one in which people trade contracts for future
delivery of securities (such as government bonds), commodities
(such as a kilogram of gold or a barrel of oil) or the value of securities
(such as the market index)
Option markets trade option contracts, which call for conditional
future delivery or purchase of a security, commodity, or a futures
contracts
Fore ig n exch o ng e mo rkets
Foreign currencies are bought and sold in the foreign exchange
ma rkets
Foreign currencies such as USD, pound, yen or euro are traded
against the lndian rupee or against other foreign currencies
They are traded for either spot or forward delivery over the counter
at large commercial banks or investment banks

Futures and option contracts trade on organized exchanges and each Futures and option contracts for foreign currencies are traded on
contract is standardized in terms of delivery amounts, instruments, organized exchanges such as the NSE
and dates

139 1"40

lnternationalization of Fina ncial Ma rkets

financial Market Efficiency
A strong financial system is a key ingredient in economic prosperity How different aspects of financial market affect the efficiency and
lncreasingly, domestic financial markets are becoming part of growth of the economy?
a
global financial system, intermediating borrowing and lending Al locationa I eff iciency
between the local nation and the rest of the world
. Necessitated by expanding international trade and production, lnformational
and the
growth of multinational corporations
. Rapid development of technology and communication systems has made
Operational efficiency
this growth possible

This places emphasis on multilateral cooperation between nations

and their central banks to ensure that the global financial system
and domestic systems are stable
. The BIS has become pivotal in encouraging this
cooperation

L4t 142

Financial Market Efficiency Financial Market Efficiency

Al I ocoti on o I effi cie ncy nformoti al effici
I on e n cy
It is a form of economic efficiency that implies that funds are lnformational efficiency is achieved when securities' orices are the
allocated to (i.e., invested in) their highest-valued use best indicators of their true value because they reflect all relevant
informal.ion about the 5ecurities
Funds could not have been allocated in any other way that would
have made society better off When new information about a security arrives in an efflcient
market, market prices adjust very quickly
Business firms invest in projects offering the highest rates of return . Analysts and investors are gathering information about securities
in a
quest for quick profits
Households invest in direct or indirect financial claims offering the . Large profits can be earned by identifying overpriced securities before
the
highest yields for given levels of risk price begins to rise
'The
actions of analysts and investors ensure that market prices
reflect all information relevant to their values at any time

L43 1.44

2
 t/10/202

Financial Market Efficiency Financial Market Efficiency

I nfo rm otio na I effi ci e ncy O pe rot i o no I effic ie ncy
It is important that market prices reflect all relevant information It is achieved in a market when the costs of conducting transactions
about securities are as low as possible (for example, broker commissions, bid-ask
With accurate price information, investors can determine which spreads and underwriter spreads)
investments are the most valuable - providing the highest expected lf transaction costs are high, fewer financial transactions will take
return for a given level of risk - and invest accordingly place
. Flrms will be prevented from investing in all the projects that they want to
This informational efficiency ensures that the financial markets are
. The forgone investment opportunities mean that
fewer people are
allocationally efflcient because households or businesses can get the employed and economic growth slows or declines
information they need to make investment decisions
Society becomes worse off

1.45 1,46

Risks Faced by Financial lnstitutions Faced by Financial lnstitutions

,,Risks
Financial institutions, in providing financial intermediation services
Credit risk
to consumers and businesses must transact in the financial markets
lnterest rate risk
They intermediate between SSUs and DSUS to earn profit by
acquiring funds at interest rates that are lower than they charge Liquidity risk
when they sell their financial products
Foreign exchange risk
The differences in the characteristics of the financial claims that
financial institutions buy and sell expose them to a variety of risks in Political risk
the financial markets
Reputational risk
During the 2OO7-2009 financial crisis, several financial institutions
failed or were bailed out by the governments Environmental risk
. Managing the risks does not mean eliminating them but trading_off
between risk and profits

147 L48

.lisks Faced by Financial lnstltutions Risks Faced by Financial lnstitutions

Credit risk: Risk that borrower willfailto make elther interest or
principal payments in the amount and at the time promised
. Financial institutions diversify their portfolios, conduit a credit analysis of
the borrower to measure default risk exposure and monitor the boriower
over the life of the loan or investment to check the borrower,s ability to
repay the loan
lnterest rate risk: Risk of fluctuations in a security,s price or
reinvestment income by changes in market interest rates
. A change in interest rates will alter forecasted cash flows and
affect the
value of interest rate sensitive assets and liabilities
. For example, if a bank issues frxed-rate loans and interest rates go up, the value of
the loaos will decline but the cost of replacing the rssued funds inc riases
. Financial institutions are exposed to interest rate risk whenever they plan
to borrow or lend at a variable rate
Liquidity risk: Risk that a financial institution will not have sufficient
cash to meet its short-term liabilities
. lf a financial institution is unable to meet its short-term obligations
because of inadequate liquidity, the firm will fail even through over the
long run it is profitable
. Banks and other deposit taking institutionsr Deposit withdrawals and payoffother
liabilities as they come due
. Superannuation fundst Contractual superannuation payments
. Life insurance companies: Pay death benefits
. llaving sufficient liquidity also ensures that an institution does not pass up
a profitable Ioan or investment opportunity because of a lack of cash

1.49 150

2

*Risks Faced by Financial Institutions
Foreign exchange risk: Fluctuation in the earnrngs or value of a
financial institution that arises from changes in exchange rates
. Many financial institutions deal in foreign currencies either on their own
account or for their customers
. Also, financial institutions invest in the direct credit markets of other
countries and sell indirect financial claims overseas
. Because of changing international economic conditions and the relative
supply and demand of local and foreign currencies, the rates at which
foreign currencies are converted into lndian rupees change
. The changes can cause gains or losses in the currency positions
of
financial institutions and the value of investments denominated in foreign
currencies
151 152
Summary
Explain the role of the financial system and why it is important to
individuals and to the economy as a whole
. The role of the financial system is to gather money from SSUs
and transfer
it to DSUs in the most efficient manner possible
. Larger the flow and more efficiently the funds are allocated, greater is the
accommodation of individual preferences for current spending and
savings and the ability of entrepreneurs/investors to invest in their firms
. Financial markets have five primary functions:
(1) facilitating the flow of funds
{2) providinB the mechanism for the settlement of transactions
(3) generating and disseminating information that assists decision makinB
(4) providing means for the transfer and management of risk, ancl
(5) providing ways of dealing with the incentive problems that arise in financial
contracting
153 154
S.-u.mmary
A variety of financial intermediaries operate in the economy
. Central banks, commercial banks, NBFC, and other private instiiutions
Financial claims of different natures and types are bought and sold in
financial markets
. Range of markets deal with financial claims of different natures and types
. Money markets: Short-term wholesale market, less risk involved
Governments, conimerciatbantsand burinss.s.r,u{ their tiqurdiryporr,onsbyborrowing
'
or lendinE in this market
. Centr.l banksconductsmonerarypolicythroughmoneymarkets
. lrdmple: Comme(iat prper, Trersury.norB
. Capttal markets: Market for long term securitier, more riskv
. Governm"nls/bur,r.5\es obrrin fLrds Ior tonq{prm rnveiim€nrs
. ConsJme,! f,nance pLr.h"5es ot tonsrerm d!+ts
. txamples: Corporate *ock, Ue.sury bonds, mo(8.ges
Financial claims are initially sold in the primary markets and then
traded in secondary markets
155 156
L11.0/202
*lisks Faced by Financial lnstitutions
Political risk: Risk of fluctuation in value of a financial institution
resulting from the actions of the domestic and foreign governments
Reputational Risk: Potential for negative publicity of a financial
institution to cause costly litigation, or revenue reductions
Environmental risk: Climate change and environmental litigation are
increasingly being recognized as key risk factors for financial
i nstitutions
. Financial sector is a comparatively low emission sector, however, risk
arises as a provider of capital to businesses
. Climate change (such as extreme weather events and sea level rises) has a
significant jmpact on business performance and therefore on assets and
insurance portfolios
. Significant regulatory risk as governments respond to climate change and
other environmental concerns
*!_lpmary
Two basic ways the transfer of funds takes place in an economv
. Direct: Whblesale financial claims in which DSUs and SSUs
Wholesale market for financial
trade financial claims directly among themselves
' BroLcrs, dpaler, and invpstmeht bankpis tacrlilatothpse trinsactions
. lndirect:
Financial institutions intermediate between DSUs and SSUs
. Commercial banks, lileinsurance companies, pension funds, and mutual funds
Financial intermediaries provide five fundamental services
. Denomination divisibility: Producing financial claims of varvins amounts
. Lurrency transtormation: Buying financial claim.s denominated in one
currency and selling financial clJims
. Maturiiy flexibilityacreating financial denominated in another
claims with a wide range of
maturities
. Credit risk diversification: Diversifying risk more efficiently than individual
SSUs
. Liquidityr Buying direct financial claims with low liquidity and issuing
indirect financial claims with more liquidity
Summary
Financial institutions are profit-maximizing businesses that earn
profits by acquiring funds at interest rates lower than those they
earn on their assets
The nature and characteristics of the financial claims they hold
expose them to a variety of risks
The major risks that financial institutions face are credit, interest
rate, liquidity, foreign exchange, and political risks in addition to
reputational and environment risk