Financial Institutions and Market

Structure, Growth and Innovation

Chapter 1

Nature and Role of

Financial System

Copyright © 2017 McGraw Hill Education, All Rights Reserved.

PROPRIETARY MATERIAL © 2017 The McGraw Hill Education, Inc. All rights reserved. No part of this PowerPoint slide may be displayed, reproduced or
distributed in any form or by any means, without the prior written permission of the publisher, or used beyond the limited distribution to teachers and
educators permitted by McGraw Hill for their individual course preparation. If you are a student using this PowerPoint slide, you are using it without permission. 1
Learning Objective

2
Introduction
Broad Issues

 What are the necessary pre-conditions to define Financial

System?
 Do the forces of demand & supply exist in a financial system?
 Is it possible to influence the level of national
income,employment,social wellbeing through variations in the
supply of finance?
 In what way financial development itself is affected by
economic development?
 Do the free & competitive financial markets allocate
resources more efficiently?

3
Financial System
 Enhances the rate of capital formation, efficiency of the
function of medium of exchange and facilitate
allocation of resources across space and time in an
uncertain environment

4
Functions of Financial System
 Facilitates separating ,distributing, trading, hedging,
diversifying, pooling and reducing risks
 Allocates resources across space and time
 Monitors managers and exerts corporate control
 Mobilises saving
 Facilitates efficient operation of payment mechanism
 Enables economic units to exercise their time preference
 Transmutes or transforms financial claims so as to suit

the preference of both savers and investors

 Enhances liquidity & better portfolio management

5
Structure of Financial System

 Financial System : Money, Credit , Finance

 The Structure of Financial system consists of :

• specialised & non-specialised financial institutions

• organised and unorganised financial markets
• financial instruments and services which facilitates
transfer of funds

6
Structure of Indian Financial System

7
Financial Markets
 The centers or arrangements that provide facilities for demand
and supply side of financial claims and services.

 Classification of Financial Markets

• Money & Capital Markets

• Organised & Unorganised Markets
• Primary & Secondary Markets
• Formal & Informal Markets
• Official & Parallel Markets
• Domestic & Foreign Markets
• Broad & Deep Financial Markets

8
Financial Instruments & Services
 Financial Assets
 Financial securities (Primary & Secondary)

 Investment characteristics of Financial assets

• Liquidity • Maturity period
• Marketability • Tax status
• Reversibility • Buy-back options
• Transferability • Volatility of prices
• Transaction costs • Rate of return
• Risk of default

9
Equilibrium in Financial Markets

 Equilibrium is established when the expected demand

for funds (credit) for short-term & long-term
investment matches with the planned supply of funds
generated out of savings and credit creation.
(Figure A,B &C )

 Interest rate can also be fixed irrespective of the equilibrium

rate of interest i.e. Administered Interest rate (Figure D) in
order to match/adjust supply and demand for funds as per
economic policy requirement

10
contd...

11
Indicators of Financial Development
 Finance ratio
 Financial Inter-relation ratio
 New issue ratio
 Intermediation ratio
 The ratio of money to national income
 Proportion of current account deficit financed from market
 Integration of financial sector development
 Lower transaction cost
 Developed banking sector with private ownership
 Well developed supervisory system
 Efficient & large non-banking sector
 High level of current & capital account convertibility
 Well developed secondary markets in all financial assets
 More prominence of indirect rather direct technique of monetary policy

12
 Financial Sector & Economic Development

Theories on the impact of financial development on savings and

investment :

 The classical prior voluntary

savings theory

 Forced saving or Inflationary

Financing theory

 Financial Repression theory

 Financial Liberalisation theory

13
 contd...
 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
14
 contd...

 Possible pattern of relationship : Financial

development & Economic development is symbiotic

 “Demand following” financial development

Economic Growth cycle

“Supply leading” financial development

15
Cautionary view : Financial system in
development
 Little investment in financial market is based genuine long-term
expectations. ( Keynes)

 Practical implication of Efficient market.(Tobin's)

 Financial markets hardly conform to a model of perfect competition

 The casino effect of the financial market

 Crowed behavior of the market: growing deviation from equilibrium
prices (boom & bust)

 Investor behavior: trade on noise rather than fundamentals

16
 contd...

 The relation between capital and growth : Correlation

Vs. causation

 Demand side of investment rather supply of funds may

be the decisive element in take off ( Rostow)

 Real growth can not be bought with money alone

(Chandler)

17
Fundamental Questions
 Whether institutions find the most productive
investment?
 Do institutions revalue their assets & liabilities in
response to changed circumstances?
 Whether Institutions facilitate the management of risk?
 Whether financial institutions transparent in
communication?
 How effective is the regulatory and supervisory system?
 Do investors and financial institutions learn from past
mistakes?

18
Concepts : Financial Development
 Efficiency a. Information Arbitrage
b. Fundamental Valuation Efficiency
c. Full Insurance Efficiency
d. Operational Efficiency
e. Allocation Efficiency

 Financial Innovations
 Financial Engineering
 Financial Revolution
 Diversification
 Financial Repression
 Financial Integration
 Securitisation
 Braod,Wide,Deep and shallow market
19