Meaning and definition of financial system
The financial system is possibly the most important institutional and functional vehicle for economic transformation. The objective of the financial system is to “supply funds to various sectors and activities of the economy in ways that promote the fullest possible utilization of resources without the destabilizing consequence of price level changes or unnecessary interference with individual desires.” According to Robinson, the primary function of the system is “to provide a link between savings and investment for the creation of new wealth and to permit portfolio adjustment in the composition of the existing wealth. A financial system or financial sector functions as an intermediary and facilitates the flow of funds from the areas of surplus to the deficit. It is a composition of various institutions, markets, regulations and laws, practices, money manager analyst, transactions and claims and liabilities.
Features of financial system
The features of a financial system are as follows
* Financial system provides an ideal linkage between depositors and investors, thus encouraging both savings and investments. * Financial system facilitates expansion of financial markets over space and time. * Financial system promotes efficient allocation of financial resources for socially desirable and economically productive purposes. * Financial system influences both the quality and the pace of economic development.
Constituents of Financial System
The financial system consists of four segments or components. These are: financial institutions, financial markets, and financial services. 1. Financial Institutions:
Financial institutions or financial inter-me diaries act as half- way houses between the primary lenders and the final borrowers. They borrow funds (or accept deposits) from those who are willing to give up their current purchasing power and lend to (or buy securities from) those who require the funds for meeting the current expenditures. Financial institutions are intermediaries that mobilize savings & facilitate the allocation of funds in an efficient manner. Financial institutions are generally divided into two categories (a) banks, and (b) non-bank financial intermediaries. Banking institutions are creators of credit while non-banking financial institutions are purveyors of credit. In India, non-banking financial institutions, namely, the developmental financial institutions (DFIs) & non-banking financial companies (NBFCs) as well as housing finance companies (HFCs) are the major institutional purveyors of credit. E.g. IDBI, ICICI, IFCI, SIDBI and IIBI.
2. Financial Markets
Financial markets are a mechanism enabling participants to deal in financial claims. The markets also provide a facility in which their demands & requirements interact to set a price for such claims. The financial system of a country works through the financial markets and the financial institutions. The financial markets deal with the financial assets of different types, currency deposits, cheques, bills, bonds, etc. Financial markets perform the following functions: (a) They create and allocate credit, (b) They serve as intermediaries in the process of mobilisation of saving, (c) They provide convenience and benefits to the lender and borrowers (d) They promote economic development through a balanced regional and sectoral allocation of investible funds. Financial markets are credit markets which cater the credit needs of individuals, firms and institutions. Since credit is required and supplied for short period and long period, the financial markets are broadly divided into two types: (a) money market and (b) capital market.
Money market deals with the short-period borrowing and lending of funds; in the money market, the short term securities are exchanged. Capital market deals with the long period borrowing and lending of funds; in the capital market, long-term securities are exchanged. Financial market may also be categorized into: (a) primary market, and (b) secondary market. Primary market is a market in which newly issued credit instruments are sold and purchased. Secondary market, on the other hand, is market in which previously issued credit instruments are bought and sold. The main organized financial markets in India are the money market & capital market. The first is a market for short-term securities. Money market is a market for dealing with financial assets & securities which have a maturity period of upto one year. The second is a market for long term securities, that is, securities having a maturity period of one year or more.
The capital market is a market for financial assets which have a long or indefinite maturity. Money market consists of: Call money market: Call money market is a market for extremely short period loans say one day to fourteen days. It is highly liquid. Commercial bills market: It is a market for bills of exchange arising out of genuine trade transactions. In the case of credit sale, the seller may draw a bill of exchange on the buyer. The buyer accepts such a bill promising to pay at a later date the amount specified in the bill. The seller need not wait until the due date of the bill. Instead, he can get immediate payment by discounting the bill. Treasury bills market: It is a market for treasury bills which have ‘short-term’ maturity. A treasury bill is a promissory note or a finance bill issued by the government.
It is highly liquid because its repayment is guaranteed by the government. Short-term loan market: It is a market where short- term loans are given to corporate customers for meeting their working capital requirements. Commercial banks play a significant role in this market. Capital market consists of: Industrial securities market: It is a market for industrial securities namely equity shares or ordinary shares, preference shares & debentures or bonds. It is a market where industrial concerns raise their capital or debt by issuing appropriate instruments. It can be further subdivided into primary & secondary market.
Government securities market: It is otherwise called gilt-edged securities market. It is a market where government securities are traded. In India there are many kinds of government securities- short-term & long-term. Long-term securities are traded in this market while short term securities are traded in the money market. Long-term loans market: Development banks & commercial banks play a significant role in this market by supplying long term loans to corporate customers. Long-term loans market may further be classified into: Term loans market: Mortgages market, financial guarantees market
3. Financial Instruments
Financial instruments refer to those documents which represents financial claims on assets. The financial assets or near-money assets are the claims to money and perform some functions of money. They have high degree of liquidity but are not as liquid as money is. Financial assets are of two types: (a) primary or direct assets, and (b) secondary or indirect assets. Primary assets are the financial claims against real-sector units created by real-sector units as ultimate borrowers for raising funds to finance their deficit spending; they are the obligations of ultimate borrowers. The examples of Primary assets are bills, bonds, equities, book debits, etc. Secondary assets are financial claims issued by financial institutions against themselves to raise funds from the public; these assets are the obligations of the financial institutions. The examples of secondary assets are bank deposits, life insurance policies, Unit Trust of India units, etc.
Characteristic Features of Financial Instruments
* Most of the instruments can be easily transferred from one hand to another without many cumbersome formalities. * They have a ready market, i.e., they can be bought and sold frequently * They possess liquidity, i.e., some instruments can be converted into cash readily. * Most of the securities possess security value, i.e., they can be given as security for the purpose of raising loans. * Some securities enjoy tax status, i.e., investment in these securities are exempted from income tax, wealth tax, etc., subject to certain limits. * They carry risk in the sense that there is uncertainty with regard to the payment of principle or interest or dividend as the case may be. * These instruments involve less handling costs since expenses involved in buying and selling these securities are generally much less. * The return on these instruments is directly in proportion to the risk undertaken. * These instruments may be short-term or medium term or long term depending upon the maturity period of these instruments.
4. Financial Services
Financial intermediaries provide key financial services such as merchant banking, leasing hire purchases, credit-rating, and so on. Financial services rendered by the financial intermediaries’ bridge the gap between lack of knowledge on the part of investors and increasing sophistication of financial instruments and markets. These financial services are vital for creation of firms, industrial expansion, and economic growth. Before investors lend money, they need to be reassured that it is safe to exchange securities for funds. This reassurance is provided by the financial regulator, who regulates the conduct of the market, and intermediaries to protect the investors’ interests. The Reserve Bank of India regulates the money market and Securities Exchange Board of India (SEBI) regulates capital market.
Functions or role of financial system:
1. Promotion of liquidity:
The major function of financial system is the provision of money and monetary assets for the production of goods and services. There should not be any shortage of money for productive ventures. In financial language, the money and monetary assets are referred to as liquidity. The term liquidity refers to cash or money and other assets which can be converted into cash readily without loss of value and time. 2. Link between savers and investors:
One of the important functions of financial system is to link the savers and investors and thereby help in mobilizing and allocating the savings effectively and efficiently. By acting as an efficient medium for allocation of resources, it permits continuous up gradation of technologies for promoting growth on a sustained basis. 3. Information available:
It makes available price- related information which is a valuable assistance to those who need economic and financial decision. 4. Helps in projects selection:
A financial system not only helps in selecting projects to be funded but also inspires the operators to monitor the performance of the investment. It provides a payment mechanism for the exchange of goods and services, and transfers economic resources through time and across geographic regions and industries. 5. Allocation of risk:
One of most important function of the financial system is to achieve optimum allocation of risk bearing. It limits, pools, and trades the risks involved in mobilizing savings and allocating credit. An effective financial system aims at containing risk within acceptable limit and reducing cost of gathering and analyzing information to assist operators in taking decisions carefully.
6. Minimizes situations of Asymmetric information:
A financial system minimizes situations where the information is asymmetric and likely to affect motivations among operators or when one party has the information and the other party does not. It provides financial services such as insurance and pension and offers portfolio adjustments facilities.
7. Reduce cost of transaction and borrowing:
A financial system helps in creation of financial structure that lowers the cost of transactions. This has a beneficial influence on the rate of return to the savers. It also reduces the cost of borrowings. Thus, the system generates an impulse among the people to save more. 8. Financial deepening and broadening:
A well – functioning financial system helps in promoting the process of financial deepening and broadening. Financial deepening refers to an increase of financial assets as a percentage of the gross domestic product. Financial broadening refers to building an increasing number and a variety of participants and instruments.