UNIT 1 INTRODUCTION TO FINANCIAL SYSTEM

Explain the features of financial system?

The Indian financial system has several features that help to meet the financial needs of individuals and
businesses. Here are some of the key features of the Indian financial system:
 Mobilization of Savings: The Indian financial system helps to mobilize savings from various
sectors of the economy and channel them towards productive investments. This is achieved
through various financial intermediaries such as banks, mutual funds, and insurance companies.
 Allocation of Credit: The Indian financial system also plays a key role in allocating credit to
different sectors of the economy. Banks and other financial institutions provide loans and credit
facilities to businesses and individuals to help them meet their financial needs.
 Payment System: The financial system provides a safe and efficient payment mechanism to
facilitate transactions between different individuals and businesses. This is achieved through
various payment systems such as NEFT, RTGS, and IMPS.
 Risk Management: The financial system helps to manage risks associated with financial
transactions. Financial intermediaries such as insurance companies provide risk management
products such as life insurance, health insurance, and property insurance.
 Price Discovery: The Indian financial system also helps in the discovery of prices of financial assets
such as stocks, bonds, and commodities. This is achieved through various financial intermediaries
such as stock exchanges and commodity exchanges.
 Economic Development: The financial system plays a critical role in the economic development of
the country. It provides financial resources for investment in infrastructure, industries, and other
productive sectors of the economy.
 Financial Inclusion: The Indian financial system also strives to promote financial inclusion by
providing access to financial services to individuals and businesses in remote and underdeveloped
areas of the country
Explain the role of financial system?
Financial systems play a crucial role in the economy by facilitating the flow of funds between savers and
borrowers. Here are some key points regarding the role and importance of financial systems:
1. Intermediation: Financial systems act as intermediaries between savers (those with excess
funds) and borrowers (those in need of funds). They help channel savings from individuals,
businesses, and governments to productive investments.
2. Capital Allocation: The financial system helps allocate capital efficiently by directing funds to
their most productive uses. This allocation of capital is essential for economic growth and
development.
3. Risk Management: Financial systems provide mechanisms for managing risk. Through
diversification, insurance, hedging, and other financial instruments, individuals and businesses
can mitigate various types of risks, such as market risk, credit risk, and operational risk.
4. Liquidity Provision: Financial systems provide liquidity by enabling individuals and businesses
to convert assets into cash quickly and easily. This liquidity is essential for economic transactions
and ensures the smooth functioning of the economy.
5. Price Discovery: Financial markets help determine the prices of financial assets based on supply
and demand dynamics. Price discovery is crucial for efficient resource allocation and for signaling
information about the health and prospects of companies and the economy.
6. Facilitating Economic Growth: A well-functioning financial system plays a vital role in fostering
economic growth by providing the necessary funds for investment, innovation, and
entrepreneurship. It helps mobilize savings, promote capital formation, and support economic
activities.
7. Promoting Financial Inclusion: Financial systems can also promote financial inclusion by
providing access to financial services for individuals and businesses that were previously
underserved or excluded. This can help reduce poverty, stimulate economic activity, and promote
social development.
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8. Monetary Policy Transmission: Financial systems serve as a conduit for monetary policy
transmission. Central banks use various tools to influence interest rates, money supply, and credit
conditions to achieve macroeconomic objectives such as price stability, full employment, and
economic growth.
In summary, financial systems are essential for the functioning of modern economies. They play a critical
role in mobilizing savings, allocating capital efficiently, managing risk, promoting economic growth, and
facilitating transactions. A well-developed and stable financial system is vital for overall economic
stability and prosperity.
What are the components of financial system?
Components of the Indian Financial System
Financial Institutions
Financial Institutions serve as a go-between for the investor and the borrower. The Financial Markets are
used to mobilise the investor’s funds, either directly or indirectly. A bank is the greatest illustration of a
financial institution. People who have extra money put it in savings accounts, while others who are short
on cash take out loans. The bank serves as a link between the two.
Financial institutions are further classified into two categories:
1. Banking Institutions or Depository Institutions- This category comprises banks and credit unions
that accept money from the public in exchange for interest on deposits and then lend it to those in
need.
2. Non-Banking Institutions or Non-Depository Institutions- Insurance, mutual funds, and brokerage
firms are examples of non-banking institutions or non-depository institutions. They are unable to
request monetary deposits, but they can market financial goods to their clients.
Financial Assets
Financial Assets are the items that are exchanged in the Financial Markets. The securities in the market
differ from one another based on the distinct criteria and demands of the loan applicant.
The following are some major financial assets that have been briefly discussed:
1. Call Money- It is a term used to describe a loan that is given for one day and then repaid the next
day. This type of transaction does not necessitate the use of collateral security.
2. Notice Money- It is a term used to describe a loan that is provided for more than a day but less
than 14 days. This type of transaction does not necessitate the use of collateral security.
3. Term Money- Term money refers to a deposit that has a maturity time longer than 14 days.
4. Treasury Bills, or T-Bills- These are short-term government bonds or debt instruments that
mature in less than a year. Purchasing a T-Bill entails making a loan to the government.
5. Certificates of Deposits (CDs) – These are dematerialised (electronic) forms for cash placed in a
bank for a certain length of time.
6. Commercial Paper is a type of unsecured short-term financial instrument issued by businesses.
Financial Services
Management of financial instruments (assets or securities) and liability management firms provide
services to assist in obtaining the necessary finances as well as ensuring that they are invested effectively.
India’s financial services include:
1. Banking Services- Any little or large service given by banks, such as lending money, depositing
money, providing debit/credit cards, opening accounts, and so on.
2. Insurance Services- Insurance services include services such as issuing insurance, selling policies,
insurance undertakings, and brokerages, among others.
3. Investment Services- Asset management is a common example of investment services.
4. Foreign Exchange Services- Foreign exchange services include currency exchange, foreign
exchange, and so on.
Financial Markets
A financial market is a marketplace where buyers and sellers engage and trade financial instruments
(assets or securities) like money, bonds, stocks, and other assets.
 UNIT 1 INTRODUCTION TO FINANCIAL SYSTEM
There are four different types of financial markets:
1. Capital Market- The capital market, which is designed to finance long-term investments, deals
with transactions that take place in the market for more than a year.
2. Money Market- This sort of market is only permitted for short-term investments and is dominated
by the government, banks, and other large institutions. It’s a wholesale debt market that
specialises in low-risk, high-liquid securities.
3. Foreign Exchange Market- The foreign exchange market, one of the most established marketplaces
in the world, deals with multi-currency requirements. In this market, monies are transferred
based on the foreign exchange rate.
4. Credit Market- A credit Market is a market where short-term and long-term loans are issued to
individuals or organisations by various banks, financial institutions, and non-financial institutions.
What are the functions of financial system?
Functions of financial system are discussed in brief.
1. Pooling of Funds: In a financial system, the Savings of people are transferred from households to
business organizations. With these production increases and better goods are manufactured, which
increases the standard of living of people.
2. Capital Formation: Business require finance. These are made available through banks, households
and different financial institutions. They mobilize savings which leads to Capital Formation.
3. Facilitates Payment: The financial system offers convenient modes of payment for goods and
services. New methods of payments like credit cards, debit cards, cheques, etc. facilitates quick and easy
transactions.
4. Provides Liquidity: In financial system, liquidity means the ability to convert into cash. The financial
market provides the investors the opportunity to liquidate their investments, which are in instruments
like shares, debentures, bonds, etc. Price is determined on the daily basis according to the operations of
the market force of demand and supply.
5. Short and Long Term Needs: The financial market takes into account the various needs of different
individuals and organizations. This facilitates optimum use of finances for productive purposes.
6. Risk Function: The financial markets provide protection against life, health and income risks. Risk
Management is an essential component of a growing economy.
7. Better Decisions: Financial Markets provide information about the market and various financial
assets. This helps the investors to compare different investment options and choose the best one. It helps
in decision making in choosing portfolio allocations of their wealth.
8. Finances Government Needs: Government needs huge amount of money for the development of
defense infrastructure. It also requires finance for social welfare activities, public health, education, etc.
This is supplied to them by financial markets.
9. Economic Development: India is a mixed economy. The Government intervenes in the financial
system to influence macro-economic variables like interest rate or inflation. Thus, credits can be made
available to corporate at a cheaper rate. This leads to economic development of the nation.
Write a short note of flow of funds?
The flow of funds is essentially a financial report or account that illustrates fund inflow and outflow in an
economy across different sectors operating within it on a whom-to-whom basis.
The flow of funds matrix is the form in which FOF of an economy is represented. It primarily shows six
economic sectors. These are –
 Household sector – this sector involves Non-profit organizations within an economy.
 Financial institutions.
 Non-financial corporations – this sector includes, inter alia, insurance companies, mutual funds,
pension funds, savings and loan associations.
 Government (central, state, and local).
 Savings and Investment.
 Rest of the world or foreign sector.
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Each of these sectors consists of two divisions highlighting the sources and uses of funds side by side in
the form of a matrix.
As per Flow of Funds in financial system, the heading of Sources of Funds denotes all income and
borrowing in a sector, and another heading, i.e. Uses of Funds represents all expenses and
advances/lending.
Moreover, in the flow of funds accounts, sources relate to change in the value of assets, whereas uses
relate to change in the value of liabilities.
What are the Limitations of Flow of Funds Accounts?
1. Due to its meticulous recording of sectoral financial transactions, it is difficult to analyse and
resultantly more complicated.
2. It does not account for human capital flow.
3. It is challenging to record assets, obligations, and claims sans a fixed value.
Nevertheless, despite its few limitations, the Flow of Funds approach is an exceptional financial account
to determine how a nation’s economy is performing and also helps understand its financial standing vis-
á-vis different sectors.