A Financial System is a composition of various institutions, markets, regulations, laws, practices, money managers, analysts and transactions.

The financial system performs the essential economic function of channeling funds from those who are net savers (i.e. who spend less than their income) to those who are net spenders (i.e. who wish to spend or invest more than their income). In other words, the financial system allows net savers to lend funds to net spenders.

Funds are intermediated by banks and other credit institutions, and directly via financial markets through the issuance of securities. An efficient allocation of funds, together with financial stability, contribute to economic growth and prosperity.

The most important lenders are normally households, but firms, public entities and non-residents may also lend out excess funds. The principal borrowers are typically non-financial corporations and government, but households and non-residents also sometimes borrow to finance their purchases.

Funds flow from lenders to borrowers via two routes.  In direct or market-based finance, debtors borrow funds directly from investors operating on the financial markets by selling them financial instruments, also called securities (such as debt securities and shares), which are claims on the borrower’s future income or assets.  If financial intermediaries play an additional role in the channeling of funds, one refers to indirect finance. Financial intermediaries can be classified into credit institutions, other monetary financial institutions and other financial intermediaries, and they are part of the financial system.

Significance of Financial System

1. Leads to Savings
2. That meets the funds requirements of business organisations through financial market
3. Enables Investment by business organisation to commence production of goods and services
4. Leads to Capital Formation
5. That ultimately brings economic growth

Formal & Informal Systems

Financial Institutions

• Banking
• Non-Banking

Banking Financial Institutions

Banking institutions are those institutions, which participate in the country’s payment system, i.e. they provide transaction services. They play an important role in the mobilization of deposits and distribution of credit to various sectors of the economy. A sound banking system ensures that deposits accumulated from people are productively utilized. Banking sector is dominant in India   as it accounts for nearly half of the total financial assets in the financial sector.

Non-Banking Financial Institutions

Non-banking financial institutions are those institutions which act as mere providers of credit and they do not create credit, e.g., LIC, UTI, and IDBI.

Comparison between Banking and Non-Banking Institutions

The difference between NBFC and bank can be drawn clearly on the following grounds:

1. A government authorised financial intermediary that aims at providing banking services to the general public is called the bank. An NBFC is a company that provides banking services to people without holding a bank license.
2. An NBFC is incorporated under the Indian Companies Act, 1956 whereas a bank is registered under Banking Regulation Act, 1949.
3. NBFC is not allowed to accept such deposits which are repayable on demand. Unlike banks, which accepts demand deposits.
4. Foreign Investments up to 100% is allowed in NBFC. On the other hand, only banks of the private sector are eligible for foreign investment, and that would be not more than 74%.
5. Banks are an integral part of payment and settlement cycle while NBFC, is not a part of the system.
6. It is mandatory for bank maintain reserve ratios like CRR or SLR. As opposed to NBFC, which does not require to maintain reserve ratios.
7. The deposit insurance facility is allowed to the depositors of banks by Deposit Insurance and Credit Guarantee Corporation (DICGC). Such facility is unavailable in the case of NBFC.
8. Banks create credit, whereas NBFC is not involved in the creation of credit.
9. Banks provide transaction services to the customers, such as providing overdraft facility, the issue of traveller’s cheque, transfer of funds, etc. Such services are not provided by NBFC.

Composition of Indian Financial System

Indian Financial System is composed of the following:

1. Scheduled Commercial Banks
2. Insurance Companies
3. NBFCs
4. Mutual Funds
5. Foreign Institutional Investors
6. Urban Cooperative Banks
7. Regional Rural Banks
8. National Pension System Fund

Financial Markets

Functions of Financial Markets:

The main functions of financial markets are enumerated as below:

1. To facilitate creation and allocation of credit and liquidity.
2. To serve as intermediaries for mobilization of savings.
3. To help in the process of balanced economic growth.
4. To provide financial convenience.
5. To provide information and facilitate transactions at low cost.

Financial Instruments

Financial instruments are those instruments which have a monetary value. These instruments can be classified into debt based securities and equity based securities. Equity based securities consist of equity share capital which is ownership based securities and represents risk capital. Debt based securities consists of bonds and debentures. Debenture is an acknowledgement of debt which has to be repaid in full in certain number of years mentioned at the time of issue of debenture itself. On the other hand, bonds are financial instruments issued by companies which are basically a financial contract between a company (borrower) and investors (lenders). Bonds are generally used by companies, municipalities, states and sovereign governments to raise money and finance a variety of projects and activities. Owners of bonds are debt holders or creditors of the issue.

Short-term debt-based financial instruments are issued for one year or less.  Securities of this kind come in the form of T-bills and commercial paper. Long-term debt-based financial instruments are issued for more than one year. These are bonds, debentures and loans.

Characteristics of Financial Instruments

The important characteristics of financial instruments are enumerated as below:

1. Liquidity

Financial instruments provide liquidity. These can be easily and quickly converted into cash.

2. Marketing

Financial instruments facilitate easy trading on the market. They have a ready market.

3. Collateral Value

Financial instruments can be pledged for getting loans.

4. Transferability

Financial instruments can be transferred from one person to another.

5. Maturity Period

The maturity period of financial instruments may be short term, medium term or long term.

6. Transaction Cost

Financial instruments involve buying and selling cost. The buying and selling costs are called transaction costs.

7. Risk

Financial instruments carry risk. Equity based instruments are riskier in comparison to debt based instruments because the payment of dividend is uncertain. A company may not declare dividend in a particular year. However, payment of principle or interest is more or less certain unless the company gets insolvent.

8. Future Trading

Financial instruments facilitate future trading so as to cover risks arising out    of price fluctuations, interest rate fluctuations etc.     To cater to the various credits needs of the business organizations.

Financial Services

Financial services are the economic services provided by the finance industry, which encompasses a broad range of businesses that manage money, including credit unions, banks, credit-card companies, insurance companies, accountancy companies, consumer-finance companies, stock brokerages, investment funds, individual managers and some government-sponsored enterprises.

Financial services companies are present in all economically developed geographic locations and tend to cluster in local, national, regional and international financial centers such as London, New York City, and Tokyo.

Financial services are services which involves investment, lending, and management of money and assets. Financial services are needed for the following activities:

1. Borrowing and lending
2. Investing
3. Buying and selling securities
4. Making and enabling payments and settlements
5. Managing risk

Financial Services in India

India has a diversified financial sector undergoing rapid expansion, both in terms of strong growth of existing financial services firms and new entities entering the market. The sector comprises commercial banks, insurance companies, non-banking financial companies, co-operatives, pension funds, mutual funds and other smaller financial entities. The banking regulator has allowed new entities such as payments banks to be created recently thereby adding to the types of entities operating in the sector. However, the financial sector in India is predominantly a banking sector with commercial banks accounting for more than 64 per cent of the total assets held by the financial system.

The Government of India has introduced several reforms to liberalise, regulate and enhance this industry. The Government and Reserve Bank of India (RBI) have taken various measures to facilitate easy access to finance for Micro, Small and Medium Enterprises (MSMEs). These measures include launching Credit Guarantee Fund Scheme for Micro and Small Enterprises, issuing guideline to banks regarding collateral requirements and setting up a Micro Units Development and Refinance Agency (MUDRA). With a combined push by both government and private sector, India is undoubtedly one of the world’s most vibrant capital markets. In 2017,a new portal named ‘Udyami Mitra’ has been launched by the Small Industries Development Bank of India (SIDBI) with the aim of improving credit availability to Micro, Small and Medium Enterprises’ (MSMEs) in the country. India has scored a perfect 10 in protecting shareholders’ rights on the back of reforms implemented by Securities and Exchange Board of India (SEBI).

Market Size

The Mutual Fund (MF) industry in India has seen rapid growth in Assets Under Management (AUM). Total AUM of the industry increased 25.79 per cent year-on-year to hit a record INR 22 lakh crore (US$ 342.91 billion) at the end of February 2018. At the same time the number of Mutual fund (MF) equity portfolios reached a record high of 2.27 billion in February 2018.

On account of rise in investments in the Mutual Funds and other financial instruments, the revenues of the brokerage industry in India are forecasted to grow by 15-20 per cent to reach INR 18,000-19,000 crore (US$ 2.80-2.96 billion) in FY2017-18, backed by healthy volumes and a rise in the share of the cash segment.

Another crucial component of India’s financial industry is the insurance industry. The insurance industry has been expanding at a fast pace. The total first year premium of life insurance companies grew 17.35 per cent year-on-year to reach US$ 25.44 billion during April 2017-February 2018.

Along with the secondary market, the market for Initial Public Offers (IPOs) has also witnessed rapid expansion. A total of 153 initial public offers (IPOs) were issued in the Indian stock markets in 2017, which raised a total of US$ 11.6 billion.

Over the past few years India has witnessed a huge increase in Mergers and Acquisition (M&A) activity. The total value of M&A in India rose 53.3 per cent year-on-year to US$ 77.6 billion in 2017 from US$ 50.6 billion in the preceding year.

Furthermore, India’s leading bourse Bombay Stock Exchange (BSE) will set up a joint venture with Ebix Inc to build a robust insurance distribution network in the country through a new distribution exchange platform.

Investments/Developments

• Global payments solution giant “MASTERCARD” has launched its first technology lab in Pune, which will enable India to move towards digital economy and financial inclusion.
• Four metro cities of Delhi, Mumbai, Bangalore and Chennai can reap benefits of US$ 7.2 billion annually by increasing payments through digital means.
• BankBazaar, a financial marketplace start-up in India, raised US$ 30 million in a funding round led by Experian Plc, a credit rating agency based in UK, taking the company’s total funding to US$ 110 million.
• Private equity (PE) investments in India increased 59 per cent to US$ 24.4 billion in 2017, with average deal size of US$ 42.8 million, according to data provided by Venture Intelligence.

Road Ahead

• India is today one of the most vibrant global economies, on the back of robust banking and insurance sectors. The relaxation of foreign investment rules has received a positive response from the insurance sector, with many companies announcing plans to increase their stakes in joint ventures with Indian companies. Over the coming quarters there could be a series of joint venture deals between global insurance giants and local players.
• The Association of Mutual Funds in India (AMFI) is targeting nearly five fold growth in assets under management (AUM) to INR 95 lakh crore (US$ 1.47 trillion) and a more than three times growth in investor accounts to 130 million by 2025.
• India’s mobile wallet industry is estimated to grow at a Compound Annual Growth Rate (CAGR) of 150 per cent to reach US$ 4.4 billion by 2022 while mobile wallet transactions to touch INR 32 trillion (USD $ 492.6 billion) by 2022. (Source: www.ibef.org)

The various types of financial services are briefly explained as below:

1. Investment Banking

Companies need cash in order to grow and expand their businesses; Investment banks sell securities to public investors in order to raise the cash. These securities come in the form of stocks or bonds. Thus, Investment banks are essentially financial intermediaries, who assist their clients in raising capital either by underwriting their shares or bonds or by acting as an agent (merchant banker) in the issuance of securities.

2. Credit Rating

Credit Rating means an assessment made from credit-risk evaluation, translated into a current opinion as on a specific date on the quality of a specific debt security issued or on obligation undertaken by an enterprise in terms of the ability and willingness of the obligator to meet principal and interest payments on the rated debt instrument in a timely manner.

Thus, Credit Rating is:

• An expression of opinion of a rating agency.
• The opinion is in regard to a debt instrument.
• The opinion is as on a specific date.
• The opinion is dependent on risk evaluation.
• The opinion depends on the probability of interest and principal obligations being met timely.

Such opinions are relevant to investors due to the increase in the number of issues and in the presence of newer financial products viz. asset backed securities and credit derivatives.

3. Consumer finance

Consumer credit provides short term/medium term loans to finance purchase  of  goods  or services for personal use. There are four important sources of consumer finance viz manufacturers/sellers/dealers, finance companies, banks and credit card companies.  In the past, banks provided finance to manufacturing organizations. The consumers borrowed money from the sellers/dealers directly. Finance companies too entered this arena while credit card entitles with the support from banks started operating with substantial success.  Both nationalized and private sector banks have started marketing aggressively for a large slice of the market share in this consumer finance segment. Employers also provide loan facilities to salary earners as a part of welfare scheme for their employees. In big concerns, employees organize themselves into co-operative credit societies and funds raised by its members through periodical contributions are used as loan assistance at low rate of interest.

4. Factoring

This concept has not been fully developed in our country and most of their work is done by companies themselves. All units’ particularly small or medium size units have to make considerable efforts to realize the sale proceeds without much success creating functional difficulties for such units.

Many a units under small-scale sector have become sick only because of delay/non-realisation   of their dues from large units. Introduction of factoring services will, therefore, prove very beneficial for such units as it will free the units from hassles of collecting receivables to enable them to concentrate on product development and marketing.

5. Housing Finance

The volume and growth rate across time periods are in housing loans are viewed as one of the important barometers of measuring growth in an economy. The demand for Housing Finance comes from:

• Salary earners and self-employed professionals with their basic need of a roof over their head.
• Nonresidents having an eye on capital appreciation of the asset or with an eye to their possible resettlement in India for NRIs.

The supply of loans comes from:

• LIC, National Housing Bank in the government sector.
• Private Sector housing companies viz. HDFC, Commercial Banks etc.
• Non Banking Finance Companies and private money lenders.

6. Asset Restructuring/Management Company

Asset reconstruction company’s (ARC) first task is to manage and convert the sick companies or those companies whose NPA’s rose to a  significant level into profitable ones. But, the  ARC’s  face the risk of suffering loss if the company they are trying to manage may land itself into insolvency. However, if properly managed, the ARC’s may be able  to  recover  them  from financial distress, convert them into profitable ones and transfer them to  worthy  candidates. ARC’s charge a commission or fee from the distressed company for their services.

Asset Management Companies (AMC’s) pool large amount of funds from various source of investors and invest these pooled resources in diverse securities by paying out proportional returns to the investors. Simply put, they help their client to invest money and buy securities.   They decide what to buy by relying on in-house research and data analytics. AMC’s charges a small fee for this sort of work.

7. Depository Services

Depository system is concerned with conversion of securities from physical to electronic form, settlement of trades in electronic segment, electronic transfer of ownership of shares and electronic custody of securities. All securities in the depositories are identical in all respects and are thus fungible. The ownership and transfer of securities take place by means of book entries, avoiding the risks associated with paper.

8. Debit Cards

Debit cards are also known as cheque cards. A debit card is a plastic card that provides the cardholder electronic access to his or her bank account(s) at a financial institution. Debit cards look like credit cards or ATM (automated teller machine) cards, but operate like cash  or  a personal cheque. Debit cards are different from credit cards. While a  credit card is to “pay later,”   a debit card is to “pay now.” When one uses a debit card  his money is  immediately deducted  from his cheque or savings account.

9. Online Share Trading

Online stock trading is an internet based stock trading facility where investor can trade shares through a website without any manual intervention from the broker. It also provides investors with rich, interactive information in real time including market updates, investment research and robust analysis.

Functions of a Financial System

1. Mobilization of savings.
2. Allocations of savings.
3. Provides a payment and settlement system for the exchange of goods and services.
4. Provides a mechanism for the pooling of funds to invest in large- scale enterprises.
5. Monitor corporate performance.
6. Helps in risk reduction
7. Provide price related information

Key elements of a well-functioning Financial System

1. A strong legal and regulatory environment
2. Stable money
3. Sound public finances and public debt management
4. A central bank
5. Sound banking system
6. Information System
7. Well-functioning securities market

Financial System Design

A financial integration is a well-integrated chain of financial markets and institutions that provide financial services. Different design of financial markets is found in different countries. Financial system design can be demarcated into bank based and market based.

In countries such as Japan, France and Germany, where banks provide around 20% of the corporate financing, it is known that banks are making significant effort to develop a relationship banking culture, with long-term loans and preferential interest rates for clients with a ‘good history’. These economies can be called Bank-Based Economies.

There are also countries where the borrowing-lending activities take place through organized markets, such as London Stock Exchange, in the UK, or New York Stock Exchange in USA. These are known as Market-Based Economies. Although banks are present in these countries, they are highly competitive, the relationship with lenders and borrowers is purely limited to the transactions of granting loans or taking deposits and loans are usually granted on short-term.

Economists have long disputed which system is better than the other, often comparing GDP growth in bank-based financial systems with GDP growth in market-based financial systems. A recent study from the Bank for International Settlements shows that in bank-based economies, real GDP growth per capita is superior to the one in market-based economies, for emerging market economies (EME). After a certain limit, neither bank loans, nor bonds from the market do not lead to real GDP growth. Not only does GDP growth per capita decline for developed economies, but markets seem to have a greater contribution to the economic performances than the banks, in developed countries.

Advantages of Market Based System

1. Stock markets facilitate diversification of securities to enable the investors to reduce risks.
2. In furtherance of the above point, it can be reiterated that it helps the investors to reduce their risks.
3. Market based system provides an information system which enables investor to make an informed decision which is reflected in the stock prices, and in turn leads to efficient allocation of investment.
4. Another advantage of market based system is that they facilitate financing of new technologies.
5. Therefore, in case of emerging companies with significant financial and technological risks, a market based system is preferable.

Disadvantages of Market Based System

1. Market based system is prone to instability as market may be fluctuating in turbulent times.
2. Consequently, investors are exposed to market risk.
3. There is a free rider problem.

Advantages of Bank-based Financial System

1. Close relationship with parties.
2. Provide tailor made contracts.
3. Efficient risk sharing.
4. No free rider problem.

Disadvantages of Bank-based Financial System

1. Retards innovation and growth as banks may have preference for low risk, low return projects.
2. Impedes competition and entry of new firms because banks may collude with business managers against investors.

Difference Between Bank Based Financial System and Market Based Financial System

1. In a market based financial system, the majority of the financial power is held by the stock market and the economy is dependent on how well or poorly the stock market is performing. On the other hand, in bank based financial system, the economy is dependent on how well or poorly the banking system is doing.
2. In a market based system, banks are less dependent on interest from loans for their revenue enhancements and focuses on fee based services such as checking of accounts. However, in a bank based system, they focus their attention more on loans and are more dependent on interest from loans for their revenue increase.
3. In a market-based financial economy, the wealth is spread more unevenly while in a bank- based financial system, the economy’s wealth is more evenly spread.
4. Market based financial system constantly changes and each individual within the society has the opportunity to gain or lose on any given day. But, in bank based financial system only a few are given the opportunity to maximize their gain.
5. In a market based financial system, laws are basically set forth and carried out by the government and are basically based on civil law rather than common law. Bank based financial system is prevalent where common law legal system is mostly there.

Regulators in Financial Market

(Students are requested to study this section from ICAI study material)

1. Securities and Exchange Board of India (SEBI)
2. Reserve Bank of India (RBI)
3. Insurance Regulatory and Development Authority of India (IRDAI)
4. Pension Fund Regulatory and Development Authority (PFRDA)
5. Real Estate Regulatory Authority (RERA)