CHAPTER FIVE

FINANCIAL SYSTEM

5.1. FINANCIAL SYSTEM – AN OVER VIEW

Financial system is a set of markets for financial instruments, and the individuals and institutions
that trade in those markets, together with the regulators and supervisors of the system. The users
of the system are people, firms and other organizations who wish to make use of the facilities
offered by a financial system. The financial system consists of financial markets and institutions.
Financial institutions, as part of the financial system, facilitate the flow of funds from savers to
borrowers in the most efficient manner. Savers are known as surplus spending units (SSUs) and
borrowers are deficit spending units (DSUs). The financial system is concerned with funneling
purchasing power from surplus spending units (SSUs) to deficit spending units (DSUs). The
purpose of the financial system is to transfer funds from SSUs to DSUs in the most efficient
manner possible, either for investment in real assets or for consumption. The job of bringing
DSUs and SSUs together can be done by direct or indirect financing.

Direct Financing: In direct financing, DSUs and SSUs exchange money and financial claims
directly – DSUs issue financial claims on themselves and sell them for money to SSUs. The
SSUs hold the financial claims in their portfolios as interest bearing assets. The financial claims
are bought and sold in financial markets. Some of the institutional arrangements that facilitate
the transfer of funds in the direct credit markets are private
private placement, brokers and dealers, and
investment bankers.

Indirect Financing or Financial intermediation: Flows can be indirect if financial

intermediaries are involved. Financial intermediaries’ transformation financial claims in ways
that make them more attractive to the ultimate investor.

5.2. FINANCIAL INSTITUTIONS /INTERMEDIARIES

Financial intermediaries include commercial banks, mutual savings banks, credit unions, life
insurance companies, and pension funds. These and other financial intermediaries emerged
because of inefficiencies found in direct financing. Financial intermediaries intervene between
the borrower (DSU) and the ultimate lender (SSU). They purchase direct claims with one set of
characteristics (e.g. term to maturity, denomination) from DSUs and transform them into indirect

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claims with a different set of characteristics, which they sell to the SSU. This transformation
process is called intermediation. Firms that specialize in intermediation are called financial
intermediaries or financial institutions.

5.2.1. The Benefits of Financial Intermediation/Financial Institutions

Financial intermediaries are firms that produce specialized financial products such as business
loans, consumer installment loans, new accounts, life insurance policies, financial claims in such
a way as to make them more attractive to both DSUs and SSUs. Financial intermediaries enjoy
three sources of comparative advantage over others who may try to produce similar services:
1. Financial intermediaries can achieve economies of scale because of their specialization.
Because they handle large numbers of transactions, they are able to spread out their fixed
costs. Also, specialized equipment allows them to further lower operating costs.
2. Financial intermediaries can reduce the transaction costs involved in searching for credit
information. A consumer who wishes to lend directly can also search for information, but
usually at a higher cost.
3. Financial intermediaries may be able to obtain important but sensitive information about a
borrower’s financial condition because they have a history of exercising discretion with this
type of information.

5.2.2. Types of Financial Intermediaries/ Institutions

Many types of financial intermediaries exist in an economy. Though different, financial
intermediaries/institutions all have one function in common. They purchase financial claims with
one set of characteristics from DSUs and sell financial claims with different characteristics to
SSUs. Financial intermediaries/institutions are classified as:
1. Deposit-type /depository/ institutions
2. Contractual saving intermediaries
Non-depository institutions
3. Other types of intermediaries

1. Deposit-Type Institutions
They are the most commonly recognized intermediaries because most people use their services
on a daily basis. Depository institutions issue a variety of checking or savings accounts and time
deposits and they use the funds to make consumer, business and mortgage loans. In other words,

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they accept deposits from individuals and firms and use these funds to participate in the debt
market, making loans or purchasing other debt instruments. The major types of depository
institutions are:
 Commercial banks  referred as banking
institutions
 Savings and loans associations
 MutualReferred as nearand
savings banks, banking institutions
or
 Credit unions Thrift institutions

a) Commercial Banks: They are the largest, most important and most diversified
intermediates on the basis of range of assets held and liabilities issued. They are referred to
as the “department stores of finance”. Their main sources of fund (liabilities) are in the form
of checking accounts, saving accounts and various time deposits. Most bank deposits are
insured. The main purpose of these funds is to create a wide variety of loans in all
denominations to consumers, businesses and state and local governments. These are the
asset part of the commercial banks.
b) Savings and Loan Associations: They are specialized financial institutions obtaining most
of their funds by issuing new accounts, savings accounts, and a variety of consumer time
deposit accounts, then using the funds to purchase long term mortgage. They were designed
specifically for operating in the mortgage markets. Hence they are the largest provider of
residential mortgage loans to consumer. In addition, they are now allowed to make a limited
amount of consumer and commercial loans. In effect, they specialize in maturity and
denomination intermediation, because they borrow small amounts of money short term with
checking and savings accounts and lend long-term on real estate collateral. Besides all this,
they were originally designed as mutual association (i.e., owned by depositors) to convert
funds from savings accounts into mortgage loans.
c) Mutual Savings Banks: They are similar to savings and loans association. To the customers
the difference is simply technical. They issue consumer checking and time savings accounts
to collect funds from households, and they invest primarily in residential mortgages. They
are owned cooperatively by members with common interest such as company employees,
union members or congregation members. They were designed to encourage thrift among
the working class.
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 d) Credit Unions: They are small, non-profit, cooperative, consumer organized institutions
owned entirely by their member-customers. The primary liabilities of credit unions are
checking accounts (called share drafts) and savings accounts (called share accounts); their
investments (assets) are almost entirely short-term installment consumer loans. They are
organized by consumers having a common bond, such as employees of a given firm or
union. To use any service of a credit union an individual must be a member.

2. Contractual Savings Institutions

Contractual savings institutions obtain funds under long-term contractual arrangements and
invest the funds in the capital markets. Firms in this category are insurance companies and
pension funds. These institutions are characterized by a relatively steady inflow of funds from
contractual commitments with their insurance policy holders and pension fund participants.
a) Life Insurance Companies: They obtain funds by selling insurance policies that protect
against loss of income from premature death or retirement. In the event of death, the
policyholder’s beneficiaries receive the insurance benefits and with retirement the
policyholder receives the benefits. In addition to risk protection, many life insurance policies
provide some savings. Because life insurance companies have a predictable inflow of funds
and their outflows are actuarially predictable, they are able to invest primarily in higher
yielding, long-term assets, such as corporate bonds and stocks.
b) Pension Funds: They obtain their funds from employer and employee contributions during
the employees’ working years and provide monthly payments upon retirement. Pension funds
invest these monies in corporate bonds and equity obligations. The purpose of pension funds
is to help workers plan for their retirement years in an orderly and systematic manner.
Because the inflow into pension funds is long-term and the outflow is highly predictable,
pension funds are able to invest in higher yielding long-term securities. To increase earnings
and reduce the amounts of monthly payments needed to support a retirement income, pension
funds have in recent years invested heavily in equity securities. Funds are collected by
regular contributions from employees, usually via payroll deduction. It is not possible to
write a check against your balance in a pension fund.

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3. Other Types of Financial Intermediaries
There are several other types of financial intermediaries that purchase direct securities from
DSUs and sell indirect claims to SSUs. These include: Finance companies, mutual funds, money
market mutual funds and investment companies.

5.3. FINANCIAL INSTRUMENTS

Financial instruments which are alternatively known as credit instruments or debt instruments or
financial assets. They are defined as “written evidences of the extension of credit.” Through
credit instruments, it is possible to transfer debt form one borrower to another or from one lender
to another lender. Credit instruments have the following common features or components: The
identity of the debtor, the amount of the debt, the arrangements as to maturity and repayment
arrangements.

Credit instruments can be broadly classified as: Negotiable credit instruments and non-negotiable
credit instruments. They are similar in terms of marketability. Therefore, they can be used to
transfer debt from one person to another. However, they are different in certain aspects like the
rights of those who are a party to the transactions when the debt is made and when it is
transferred. Negotiable credit instruments give better title or right on the instrument to the
transferee than the transferor. But the transferee in the non negotiable credit instruments will
have only a right similar with the transferor. The transferor and transferee will stand on the same
position.

Non-Negotiable Credit Instruments: They are covered under a contract law. Payment in non-
negotiable instruments is conditional i.e., the buyer (debtor) can refuse payment at maturity on
his own ground. Examples are money orders and postal orders, deposit receipts, share
certificates, bills of lading, dock warrants, etc. They can be transferred by delivery and
endorsement but they are notable to give better title to the bona fide transferee for value than
what the transferor has.

Negotiable Credit Instruments: It is defined as any writing that is signed by the maker or
drawer, an unconditional promise or order to pay a certain sum of money, payable on demand or
at a fixed or determinable future date, and payable to order or to bearer. They can be transferred
by delivery (if made payable to the bearer) and by endorsement and delivery (if made payable to

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the order). They give a better title to a bona fide transferee for value than what the transfer or
have. They are either promises to pay or an order to pay. It includes promissory note,
commercial paper, treasury bills, repurchase agreement, bonds, stocks, and so on.

5.4. FINANCIAL MARKETS

Financial system of any country consists of two components: Financial markets and financial
institutions. Financial market is an institution or arrangement that facilitates the exchange of
financial assets, including deposits and loans, corporate stocks and bonds, government bonds,
etc. Financial markets can be classified into different categories based on different factors as
follows:
a) According to the nature of the instruments traded
On the basis of this factor a financial market can be reclassified as primary and secondary
markets. They will be discussed here under.
i. Primary markets: They are financial claims sold by deficit spending units in a primary
financial markets. Surplus spending units are wiling to buy financial claims with their
surplus savings because they want to earn future returns. Initial buyers of financial claims
are attracted because they believe that the future pay off from owning the claim will be
large relative to the risk of loss.
ii. Secondary financial markets: are markets where by existing financial assets are bought
and sold. They let people exchange “used” or previously issued financial claims for cash
at will.
b) According to the purpose of the instruments traded
Financial markets can be classified as: Debt, equity and financial service markets.
i. Debt markets: Lenders provide funds to borrowers for some specified period of time. In
return for the funds, the borrower agrees to pay the lender the original amount of the loan
(principal) plus some specified amount of interest. They use to buy new cars and houses,
to working capital and new equipments and to finance various public expenditures. New
funds occur in the primary debt market. Assets in the debt market are further classified
as: short-term (if the underlying obligation when issued is one year or less, intermediate
(between one and ten years and long term (more than 10 years)

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 ii. Equity markets: In these markets ownership of tangible assets (such as houses or shares
of stock are bought and sold. New houses and new issues of stock are sold in primary
markets. Existing houses and shares of stock are traded in the secondary markets.
iii. Financial service Markets: Individuals and firms use financial service markets to
purchase services that enhance the workings of debt and equity markets. For instance:
commercial banks (provide depositors many services), brokerage services (they are
intermediaries who compete for the right to help people buy or sell something of value),
insurance services (give some means of insuring against various forms of loss), etc. There
is no secondary markets for financial service markets.
c) Organized exchanges and over-the-counter markets
Organized security exchanges provide a physical meeting place and communication
facilities for members to conduct their transactions under a specified set of rules and
regulations. Only members of the exchange may use the facilities and only securities listed
on the exchange may be traded.
Financial claims also can be traded “over the counter” by visiting or phoning an “over-the-
counter” dealer or by using a computer system that links over-the-counter” dealer or by using
a computer system that links over-the-counter dealers. Over-the-counter markets have no
central location. Usually, however, they have strict rules that must be followed by dealers in
the market.
Over-the-counter securities dealers “make a market” in a security by quoting a “bid” price at
which they are willing to buy the security and an “ask” price at which they are willing to sell
the security. They can make money by selling at a higher price than the price they paid to
buy the security. Thus, they profit from their bid-ask spreads.
spreads.
d) Spot, Futures and Forward Markets
The spot market involves the exchange of securities or other financial claims for immediate
payment. The term “immediate” can mean a day or a week depending on the terms of
settlement procedures in the particular market. The spot market is also called the “cash”
market.
A Future market is a market in which people trade contracts for future delivery of securities
(such as government bonds), cash goods (such as a kilo of gold) or the value of securities

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 sold in the cash market. The future contract “delivery” date is the future time when the
contract is scheduled to be settled by the exchange of cash for the contracted “goods”.
If a contract for the future delivery of cash in exchange for a foreign currency or a security is
negotiated and sold over the counter; rather than through an exchange, it is referred to as a
forward contract and the market in which it is negotiated is known as the forward market.
market.
e) Option Markets
Options markets trade options contracts that call for conditional future delivery of a security
or good or futures contracts. Options contracts call for one party (the option writer) to
perform a specific act if called upon by the option buyer or owner. Typically, an options
contract gives the buyer the right to either buy or sell a security, depending upon whether the
option is a “call” or “put” option. Call options give the buyer the right to buy a
predetermined amount of a security at the predetermined exercise or strike price on, or
possibly before, the expiration date of the option. Put options give the buyer the right to sell
a predetermined amount of a security at the pre agreed price prior to the option’s expiration
date.
f) Foreign exchange market
The foreign exchange market is the market on which foreign currencies are bought and sold.
Foreign currencies such as the British pound, Japanese yen, German mark, or French franc
are traded against other foreign currencies.
g) International and domestic markets
Financial markets can be classified as either domestic or international markets depending
upon where they are located.

5.5. MONEY MARKETS AND CAPITAL MARKETS

5.5.1. Money Markets
The money market is a market for short-term instruments that are close substitutes for money.
The short-term instruments are highly liquid, easily marketable, with little chance of loss or low
default risk and low cost of executing transactions. It provides for the quick and dependable
transfer of short-term debt instruments maturing in one year or less, which are used to finance
the needs of consumers, business agriculture and the government. Money markets are markets in
which commercial banks and other businesses adjust their liquidity position by borrowing,
lending or investing for short periods of time. In the money market, businesses, governments,
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and, sometimes, individuals borrow or lend funds for short periods of time – usually 1 to 120
days commercial paper, repurchase agreements, federal funds, promissory notes, treasury bills,
certificates of deposits, bill of exchange call and notice money and banker’s acceptances also are
important money market instruments. The money markets are also distinct from other financial
market in that they are wholesale markets because of the large transactions involved. Money
market transactions are called open market transactions because of their impersonal and
competitive nature. There are no established customer relationships.

Economic Role of the money market

The most important economic function of the money market is to provide an efficient means for
economic units to adjust their liquidity positions. Money markets help governments, businesses,
and individuals to manage their liquidity by temporarily bridging the gap between cash receipts
and cash expenditures. If a firm is temporarily short of cash, it can borrow in the money market;
or if it has temporary excess cash, it can invest in short-term money market instruments. In doing
so a money market performs a number of functions in an economy.
 It provides funds
 It helps to use surplus funds
 It eliminates the need to borrow from banks
 It helps government to borrow money at a lower interest rate
 It helps the implementation of the monetary policies of the central bank
 It facilitates the financial mobility from one sector to the other
 It promotes liquidity and safety of financial institutions
 It brings equilibrium between demand and supply of funds
 It economizes the use of cash.

Characteristics of the Money Market

Money markets may be developed and undeveloped markets. Their characteristics can be
presented as follows.
i. Characteristics of an Undeveloped Money Market
The main characteristics of such a market are:

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1. There is Personal Touch: The lender and borrower are known each other and decision made
in this market are not rational and objective.
2. There is flexibility in loans: The amount of the loan depends upon the nature of security or
the borrowers good will with the moneylender.
3. Multiplicity of Lending Activities: Money lending activity is combined with other economic
activities i.e., money lending is not the only activity of the moneylender.
4. Varied Interest Rates are Applied: The rate depends on the need of the borrower, the amount
of the loan, the time for which it is required and the nature of security.
5. Defective Accounting System: The accounts of the moneylenders are not liable to checking
by any higher authority.
6. Absence of link with the developed Market: There is no established channel to create a link
between the developed and undeveloped markets. The undeveloped money market consists
of the moneylenders, the indigenous bankers, traders, merchants, landlords, brokers, etc.

ii. Characteristics of a Developed Money Market

The main characteristics of such a market are:
1. It is a well-developed market and consists of the central bank, the commercial bank, bill
brokers, discount houses, acceptance houses, etc.
2. The central bank controls, regulates and guides the entire money market
3. It consists of a number of specialized sub markets dealing in various types of credit
instruments such as the call loan market, the bill market, the treasury bill market, the
collateral loan market, the acceptance market and the foreign exchange market.
4. It has a large number of near money assets of various types such as: bills of exchange,
promissory notes, treasury bills, securities, bonds, etc.
5. It has an integrated interest rate structure. The change in the bank rate leads to proportional
changes in the interest rate prevailing in the sub-markets.
6. It has an adequate financial resources form both within and outside the country.
7. It provides easy and cheep remittance facilities for transferring funds from one market to
the other.
8. It is highly influenced by such factors as restrictions on international transactions, crisis,
boom, depression, war, political instability, etc.

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5.5.2. The Capital Market
The capital market is a market which deals in long-term loans. It functions through the stock
exchange market. A stock exchange market is a market which facilitates buying and selling of
shares, stocks, bonds, securities and debentures for both new and old ones. It supplies industry
with fixed and working capital and finances medium-term and long-term borrowings of the
central, state and local governments. It deals in ordinary stocks, shares and debentures of
corporations and bonds and securities of governments. The funds which flow in to the capital
market come from individuals who have savings to invest, the merchant banks, the commercial
banks, and non bank financial intermediaries, such as insurance companies, finance houses, unit
trusts, investment trusts, venture capital, leasing finance, mutual funds, building societies, and
underwriting companies.

Importance or Functions of Capital Market

The capital market helps in capital formation and economic growth of the county. The
functions/importance are discussed as follows:
1. It acts as an important link between savers and investors
2. It gives incentives to savers and investors
3. It brings stability in the value of stocks and securities
4. It encourages economic growth

5.5.3. Distinction Between Money and Capital Markets

The money market differs from the capital market on several grounds.
1. The money market deals in short-term funds, whereas, the capital market deals in long-term
funds.
2. The money market uses short-term instruments, such as promissory notes, bills of exchange,
treasury bills, certificates of deposits, commercial papers, etc. whereas; the capital market
uses long-term securities such as shares, debentures, bonds of industrial concerns and bonds
and securities of the government.
3. Institutions operating in the two markets differ. In the money market: the central bank,
commercial banks, non-bank financial intermediaries and bill brokers operate. In the capital

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 market, stock exchange, mutual funds, insurance companies, leasing companies, investment
banks, investment trust, etc, operate.

5.5.4. Interrelation Between Money And Capital Markets

These markets are closely interrelated because most corporations and financial institutions are
active in both. Their interrelation is discussed as follows:
1. Lenders may choose to direct their funds to either or both markets depending on the
availability of funds, the rates of return and their investment policies.
2. Borrowers may obtain their funds from either or both markets according to their
requirements.
3. Some corporations and financial institutions serve both markets by buying and selling short-
term and long-term securities.
4. All long-term securities become short-term instruments at the time of maturity. So some
capital markets instruments also become money market instruments.
5. Funds flow back and forth between the two markets whenever the treasury finances maturing
bills with treasury securities or whenever a bank lends the proceeds of a maturing loan to a
firm on a short-term basis.
6. Yields in the money market are related to those of the capital market. As the long-term
interest rates fall, the short-term interest rate will fall. However, money market interest rates
are more sensitive than are long-term interest rates in the capital market.

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