FINANCIAL INSTITUTIONS AND

MARKET

INTRODUCTION TO
INDIAN FINANCIAL SYSTEM
SAVING

is a process where one puts away small amounts of money to

add up to a certain large amount.
INVESTING

•  is a process whereby one puts away "surplus" money to

generate more money(returns) for us in the future.
AVENUES TO INVEST

SECURITIES FORM OF INVESTMENT NON-SECURITIES FORM OF INVESTMENT

• National Saving Certificate
• Corporate Bonds/Debentures
• National Saving Schemes
• Government Bonds
• Provident Funds
• Preference Shares
• Corporate Fixed Deposits
• Equity Shares
• Life Insurance Policies
• Mutual Funds
• Post Office Savings
• Financial Derivatives
• Kisan Vikas Patra
Futures
• Bank Deposits
Forwards
• Real Estate
Options
• Gold/Silver/Precious Stone/Art
Swaps
• Chit Fund
CORE PRINCIPLE BEING - FIRST SAVE THEN INVEST.
NATIONAL INCOME---GDP

• National Income (GDP) ie. Y in a closed economy can be

expressed as Y = C + I + G
• Where: C consumption, I investment, & 
government Expenditure/ purchases.
• National savings can be thought of as the amount of
remaining money that is not consumed, or spent by
government. In a simple model of a closed economy, anything
that is not spent is assumed to be invested.
• National saving is the total income in the economy that
remains after paying for consumption and government
purchases.
• National Saving S= I = Y – C - G
DERIVATION OF NATIONAL INCOME

• National Saving = Private Saving + Government/ Public Saving

S = (Y– C – T ) + (T – G)
S = Y – C – G –T + T
S = Y–C–G
I= S = Y–C-G

*In closed economy, whatever is saved is invested. thus

Private saving is the amount of Public saving is the amount of

income that households have left tax revenue that the
after paying their taxes and paying government has left after
for their consumption. paying for its spending.
Private saving = (Y – C – T) Public saving = (T – G)
THE MEANING OF SAVING AND INVESTMENT

• Surplus and Deficit

–If T > G, the government runs a budget surplus because it receives
more money than it spends.

–If G > T, the government runs a budget deficit because it spends

more money than it receives in tax revenue.

–INDIA –surplus or Deficit?

 SUPPLY & DEMAND FOR LOANABLE FUNDS

Interest Supply S
rate
A
4%

Deman
d
0 Rs Supply of
1000 loanable
funds

• Supply of Loanable funds coming from national savings

• The demand of loanable funds coming from household and
firms who wish to borrow for investments
• Interest rates is the price of the loan to adjust the balance
between supply and demand for loanable funds
Government policies that affect savings and investment
In turn Demand and Supply curve

Taxes and saving i.e. Saving Incentive

Taxes and investment

Government Budget
1. SAVING INCENTIVE

If tax rate is decreased people will save more.

‡ The supply curve of loanable fund will shift to right.
‡ That will decrease the equilibrium interest rate.
‡ Will increase the quantity demand for loanable fund.

Interest Supply S
rate S’

A
4%

3% B

Demand

0
Rs 1000 Rs 1500 Supply of
loanable funds
2. INVESTMENT INCENTIVE
• Change in the tax system encourage corporates & incentive to
borrow.
¤ Increase the demand for loanable funds.
¤ Shift the demand curve to right.
¤ Increase the interest rate due to increase in demand and same supply.
Supply
Interest
rate
B
4%

3% A

D’
D
Demand

0
Rs 1000 Rs1500 Supply of
loanable funds
3. GOVERNMENT BUDGET DEFICIT OR SURPLUS

• Deficit: Government spend more than its tax revenue.

‡ Change in government budget balance represents a Change in the
public saving and in supply of loanable funds
‡ Budget Deficit: Shift the supply curve to left.
‡ Increase the equilibrium interest rate.
‡ Reduces the equilibrium quantity of loanable funds.

Supply S’

Interest S
rate
B
4%
3% A

D
Deman
0 d
Rs 800 Rs1000 Supply of
loanable funds
3. GOVERNMENT BUDGET DEFICIT OR
SURPLUS
• Budget Surplus: Government spend less than its tax
revenue.
‡ Shift the supply curve to right.
‡ Decrease the equilibrium interest rate.
‡ Increase the equilibrium quantity of loanable funds.
Supply S

Interest S’
rate
A
4%
B
3%

D
Demand
0 Rs 800 Rs1000 Supply of
loanable funds
DETERMINANTS OF SUPPLY AND DEMAND FOR FUNDS
DEMAND FOR FUNDS SUPPLY OF FUNDS
• Investment in working capital • Volume of saving
– Current level of capital stock v/s • Level of income v/s expected income
desired level • Cyclical changes in income
– Capacity uitlisation • Wealth
– Demand for goods • Inflation
– Government policies • Family members
– Price fluctuations • Contingencies
– Availability of internal funds • Thrift

– Cost of funds • Rate of interest

• Development of banks
– technological changes
• Investment avenues
– profitability
• Demand for consumer durables
– Change in taste & preference
– Fashion
• Investment in housing
 Money

Credit or Loan

Finance
FINANCIAL SYSTEM

• The financial system is concerned about money, credit and

finance-the three terms are intimately related yet are
somewhat different from each other.
• Money refers to the current medium of exchange or means of
payment.
• Credit or Loan is a sum of money to be returned normally
with interest it refers to a debt of economic unit.
• Finance is a monetary resources comprising debt &
ownership fund of the state, company or person.
• It is said that money brings more money only when it is
properly managed; hence efficient management of every
business enterprises is closely linked with efficient
management of its finance.
• Financial system comprises of complex and closely
connected or interlined institutions, financial markets,
financial instruments and services which help in the
formation of capital
• 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.
THE ROLE OF FINANCIAL SYSTEM IN THE GROWTH PROCESS : TO REDUCE THE COST OF ACCUMULATING
CAPITAL.

• Policy makers should align private incentives with public

interest in such a way that the scrutiny of financial
institutions by supervisors is supported by supervision of
market participants : Market-aware regulation

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FINANCIAL V/S ECONOMIC DEVELOPMENT

• The relationship between Financial development &

Economic development is symbiotic, mutually reinforcing
and intertwined

• “Demand following” or “passive” financial development

– increase in level of income, per capita income increase

Economic Growth cycle

• “Supply leading” financial development
–More financial instruments and institutions

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CAUTIONARY VIEW : FINANCIAL SYSTEM &
DEVELOPMENT

• Financial sector can perform the developmental role if it

functions efficiently, Financial markets hardly conform to a
model of perfect competition
• Little investment in financial market is based genuine long-
term expectations. ( Keynes)
• Insider information is used to make extraordinary gains
• Investor behavior: trade on noise rather than fundamentals
• Crowed behavior of the market: growing deviation from
equilibrium prices. Speculative bubbles
• Minimal fundamental valuation efficiency
• Information asymmetry
• Real growth can not be bought with money alone (Chandler)
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25
 ROLE/ FUNCTIONS OF FINANCIAL SYSTEM

• It serves as a link between savers and investors. It channelises flow of

saving into productive investment.
• It assists in the selection of the projects to be financed and also reviews
the performance of such projects periodically.
• It provides payment mechanism for exchange of goods and services.
• It provides a mechanism for the transfer of resources across geographic
boundaries.
• It provides a mechanism for managing and controlling the risk involved in
mobilizing savings and allocating credit.
• It promotes the process of capital formation by bringing together the
supply of saving and the demand for investible funds.
• It helps in lowering the cost of transaction and increase returns. Reduce
cost motives people to save more.
• It provides you detailed information to the operators/ players in the
market such as individuals, business houses, Governments etc.
THREE TASKS OF A FINANCIAL SYSTEM

• The three tasks of a financial system are to reduce the

problems facing borrowers and lenders:
–Transaction costs
–Risk
–Desire for liquidity
• In reducing these problems in a cost-effective way, they
enhance the efficiency of financial markets, so that lenders
and borrowers make mutually beneficial trades, which make
society as a whole richer.
REDUCING TRANSACTION COSTS

• Transaction costs are the expenses of putting together and

executing a deal.
• When a large business wants to borrow money, they can
either get a loan from a bank or sell bonds in the bond
market.
• Getting a loan from a bank avoids large transaction costs
because there is only one borrower and one lender.
• The principal reason there is a bond market is that it allows
companies to borrow large sums of money without incurring
in large transaction costs.
REDUCING RISK

• Financial risk is uncertainty about future outcomes that

involve financial losses or gains.
• Financial risk is a problem because the future is uncertain; it
holds the potential for losses as well as gains.
• A well-functioning financial system helps people reduce their
exposure to risk, by allowing them to engage in
diversification.
• Diversification is done by investing in several assets with
unrelated, or independent, risks. This lowers the total risk of
loss.
• The desire of individuals to reduce their total risk by
engaging in diversification is why there are stocks and a stock
market.
 PROVIDING LIQUIDITY

The third task of the financial system is to provide

investors with liquidity, which is important because the
future is uncertain.
An asset is said to be liquid if it can quickly be
converted into cash without much loss of value. If it
cannot, then it is said to be illiquid.
Stocks and bonds are a partial answer to the problem
of liquidity.
Banks provide a further way for individuals to hold
liquid assets and still finance illiquid investments.
COMPONENTS OF FINANCIAL SYSTEM

• Financial markets: facilitate the flow of funds in order to finance

investments by corporations, governments and individuals.
• Financial Institutions:
– Financial intermediaries: are the key players in the financial markets as
they perform the function of intermediation
– Financial regulators: perform the role of monitoring and regulating the
participants in the financial system.
• Financial Instruments: are the financial assets/securities traded
in the financial system thus channelizing the flow of funds from
lender to borrower.
• Financial Services: facilitate borrowing and funding, lending and
investing, buying and selling securities, making and enabling
payments and settlements, and managing risk exposures in
financial markets
 FINANCIAL MARKETS

Nature of Maturity of Seasoning Timing of Organization

Claim Claim of Claim Delivery al structure
• Debt • Money • Primary • Cash or • Exchange
market: Market: Market: Spot Traded
• Equity • Capital • Secondary Market: Market:
market Market: Market • Forward • Over the
or futures counter
Market Market:
FINANCIAL INSTRUMENTS/ ASSETS

• The two types of assets that exist are real assets and financial
assets.
• Financial assets are the opposite of real assets because they
are intangible claims to real assets.
• The most common financial asset in the market is money or
cash. This is so because money is the simplest medium of
exchange and store of value.
• The key here is that financial assets allow individuals to store
value and use that value in another period. In other words,
people are able to save or transfer current consumption to
the future.
FINANCIAL INSTRUMENTS/ ASSETS

• Savings and investments are linked through a wide variety of

complex financial instruments known as ‘securities.’
• A financial instrument is a claim against a person or an
institution for payment, at a future date, of a sum of money
and/or a periodic payment in the form of interest or
dividend.
FINANCIAL INSTRUMENTS DIFFER IN TERMS OF
OR
INVESTMENT CHARACTERISTICS OF FINANCIAL ASSETS

–marketability,
–liquidity,
–reversibility,
–type of options,
–Volatility of Prices
–Maturity
–Tax Status
–Transferability
–Rate of return,
–Risk of default, and
–transaction costs.
TYPES OF FINANCIAL SERVICES

• Depositories
• Custodial
• Credit Rating
• Factoring
• Forfaiting
• Merchant Banking
• Leasing
• Hire Purchase
• Guaranteeing
• Portfolio Management
• Underwriting
Basis for difference Factoring Forfaiting

Factoring is the process in which you

In Forfaiting, Exporter sell their
receive advance against account receivables
medium and long term account
Definition / Meaning / debt from the factor (bank or financial
receivables and obtain cash from the
institution) without waiting for payment in
forfaiter.
future.

Maturity of It involves account receivables of short It involves account receivables of

Receivables term maturities medium and long term maturities.

Usually 80-90 percent of the value of

Extent of Finance 100 percent of value of invoice.
invoice.
Recourse Factoring and Non Recourse
Type Non Recourse
Factoring

Factor does the credit rating in case of no Forfaiting Bank relies on the
Credit Worthiness
recourse factoring transaction. creditability of the Avalling Bank.

Factoring Cost is borne by the Client Cost of forfaiting borne by the

Cost
(seller). overseas buyer

Day to Day administration of sales and

Services Provided No Services are provided
other allied services are provided

Forfaiting is evidenced by bills of

Negoatiable
No dealing with Negotiable Instruments exchange, promissory note, a letter
Instruments
of credit.
Basis for difference Hire Purchase Leasing

is a tripartite agreement involving the seller

(Owner) , finance company and the hirer
(purchaser). the seller transfers ownership
Agreement type
of the goods to a Finance Company, usually
at a discounted price, and it is this company
that hires and sells the goods to the buyer.  
is only a bipartite agreement,
involving lessor and lessee. Lessor is
the owner, lessee is the tenant for the
period of agreement

ownership passes on to the buyer only on only in financial lease, the ownership
Transfer of ownership
the last installment from the finance will get transferred. While in operating
company.  lease, the ownership is not transferred.

Depreciation Claim claimed by the purchaser / hirer in a hire Depreciation is claimed by the lessor
purchase. during the life of lease agreement

Payments include the principal amount and

Rental payments are the cost of using
Payments the effective interest for the duration of the
the asset
agreement

Only interest component is categorized as Lease rentals categorized as

Tax Impact
expenditure by the hire expenditure by the lessee

Responsibility of the lessee in the

Repairs and
Responsibility of the hirer financial lease, and of the lessor in
Maintenance
operating lease
THANK YOU