Understanding the Financial System: A Comprehensive Overview

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Introduction
To Financial
System
 
 
The economic development of any nation is reflected
by the progress of the various economic units, broadly
classified into corporate sector, government and
household sector.
The units in these sector are always placed in a
surplus/deficit/balanced situation, which gives rise to
the process of lending and borrowing.
There are units or people with surplus funds and there
are those with a deficit.
Surplus units 
refers to those who have excess funds or
excess income over expenditure and wants to invest.
They are known as 
Savers or Investors
.
Deficit units 
refers to those having lack of funds and
need to borrow. They have excess expenditure over
income. They are known as 
Borrowers
.
 
They share a 
mutual need 
of investing and borrowing
by way of an financial transaction.
The financial transaction is carried out at a common
place known as 
Financial Market 
linked by  
Financial
Intermediaries
 and thru the medium of 
Financial
Instruments
.
The entire mechanism of mobilizing savings, investments
and creating credit in an economy thru economic units
for productive purpose is termed as 
Financial System
.
A financial system or financial sector functions as an
intermediary and facilitates the flow of funds amongst
the various units.
People from the areas of surplus provide funds to the
areas of deficit.
 
 
 
Finance  +  System  =  Financial System
Finance
 
means monetary resources
comprising ownership funds and debts.
System
 indicates a set of interrelated parts
working together to achieve some purpose.
Financial System 
refers to mobilizing surplus
funds from people and organisations and to
allocate them among deficit people and
organisations.
An 
investor
 is an example of a Surplus Unit
whereas a 
borrower
 is an example of a
Deficit unit.
 
Financial System
 
Definitions
 
The financial system is a set of institutional
arrangements thru which financial surpluses
available in the economy are mobilized.
The financial system consists of a variety of
institutions, markets and instruments related in a
systematic manner provide the principal means
by which savings are transformed into investments.
A financial system is a set of systematically
integrated constituents which enables smooth
flow of finance from areas of surplus to areas of
scarcity in such a way that risk is redistributed and
economic development is accelerated.
 
 
Thus we can infer from the definitions that :-
1.
The financial system is composed of 
several
constituents
.
2.
All the constituents are 
related
 to each other.
3.
These constituents come together in the system
and 
mobilise savings
.
4.
Savings and the resultant investment leads to
economic development
.
 
Features of the Financial System
 
1.
It is a composition of various institutions, markets,
regulations, laws, practices, transactions, claims and
liabilities.
2.
It plays a vital role in the economic development of
the country.
3.
It encourages both savings and investments.
4.
It links savers and investors.
5.
It helps in capital formation.
6.
It promotes efficient allocation of financial resources
for socially desirable and economically productive
purposes.
7.
It facilitates expansion of financial markets.
8.
It helps in creation of financial structure that lowers the
cost of transactions.
 
Functions of Financial System
 
1. Payment System
 
Financial system helps for payment of goods and
services. It provides a payment system for the
exchange of goods and services.
We find that majority of buyers and sellers of
products or services prefer to pay and receive
money thru banks to avoid the risk of carrying
cash in large amount. (Banks, credit cards, debit
cards etc.)
 
2. Link between savers and
investors:
 
One of the important function of financial system
is to link the savers and investors and thereby help
in mobilizing and allocating the savings effectively
and efficiently.
For ex : A person opening savings banks account
or invests money in shares it means that they are
using the financial system for channeling savings
into the economy.
 
3. Pooling of Funds
 
Modern business organisations require large
investments which are often beyond the means
of an individual or groups of individuals.
Financial Markets and intermediaries which are
an integral part of the financial system facilitates
the pooling of household savings for financing
business.
Thus it enables households to participate in large
enterprises. Small savings are pooled together
and transformed into large amounts which
promoters of business can avail to meet their
financial needs.
 
4. Transformation of savings into
Capital / Investment
 
The savings are then channelized towards
entities/persons who demand finance thru the
medium of equity or debt.
The money thus raised is used to expand operations,
start new projects etc.
 
5. Reduces the 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.
 
6. Risk Management
 
The financial system helps to reduce the risk of savers.
Financial institutions like banks and mutual funds
mobilise fund from the savers and lends them to
borrowers and thereby bears the risk of borrowing.
For ex : When a bank uses public deposits to lend to
institutions, it is passing on the funds from savers to
borrowers. However if a particular borrower does not
repay the bank, the bank bears the loss and does not
pass on that loss to the borrower thereby redistributing
the risk.
 
7. Economic Development
 
By transforming savings into capital and
redistributing risk, the financial system enables
smooth flow of funds to productive and scarce
areas.
This leads to higher production and increases
employment and consumer demand, accordingly
more goods are available and more people are
willing to purchase them.
 
8. Provision of Liquidity
 
The financial system provides a mechanism for
an investor to sell securities whenever there is the
need for cash.
 
9.  Price Information
 
Financial markets provide information that helps
in coordinating decentralizing decision making.
Price information such as interest rates and
security prices are used by households or their
agents in making their consumption – saving
decisions and in deciding their wealth allocation
portfolio.
 
Evolution of the Financial
System
 
The Indian Financial System falls into 3 different
phases :
Pre Independence upto 1951
Post Independence 1951 - 1990
Post 1991
 
 
Pre Independence up to 1951
 
The structure of Indian Financial System during the
Pre Independence Era was that of a traditional
economy.
The main features of the financial system pre 1951
was that of a closed economy consisting of :
Semi organised Securities Market.
Closed circle Industrial Entrepreneurship
Restricted access to foreign savings
Absence of financial institutions in long term
industrial financing.
 
Post Independence upto 1990’s
 
During the post independence period there has
been a significant growth in the Indian Financial
System in terms of quantitative indicators as well
as in diversification and innovations.
This period was the progressive transfer of its
important constituents from private ownership to
public ownership.
An overview of the development of the Indian
Financial System in the post independence
period up to 1990’s are as under :
1.
Nationalisation of Banks & Insurance Sector.
2.
Developmental Banks/Institutions.
3.
Investor Protection
 
1. Nationalization of Banks &
Insurance Sector
 
The post 1951 phase was a landmark era in the
history of Indian Financial System with the
nationalisation of RBI and SBI.
In 1969, 14 major commercial banks were
brought under direct control of government of
India.
The nationalisation of LIC and GIC was yet
another historical measure.
 
2. Development Banks / Institutions
 
In addition to nationalization, the govt created a
wide range of new institutions in the public
sector.
The institutions were created to cater to the
financial needs of industries and between them
cover the whole range of Industry.
The public sector occupied a commanding
position in the industrial financing system in India
ex ; SIDBI, IFCI, IDBI, UTI etc.
 
3. Investors Protection
 
During this period, there were gross
mismanagement of companies, corporate frauds
and abuses which results in loss of public
confidence in corporate securities market.
To restore investor faith and confidence, the
government adopted drastic measures such as :
The Companies Act, 1956
The Capital Issues Act, 1947
Securities Contracts Act, 1956
Monopolies & Restrictive Trade practices Act, 1970
Foreign Exchange Regulation Act, 1973
 
Post – The New Industrial Policy 1991
 
The declaration of the New Industrial Policy
witnessed a profound transformation in the Indian
Financial System.
The conservative philosophy of the development
process in India shifted to free market economies.
The notable developments in the Indian Financial
System during this phase are :
 
1. From Public Control to Private
Ownership
 
The major steps initiated during this phase were to
privatize important financial institutions.
The conversion of the IFCI into a public limited
company.
IDBI offering their equity to private investors were
all the part of privatization of financial institution.
The setting up of private mutual funds and banks
under the guidelines of RBI also came into
existence.
 
2. Transformation of Institutional
Structure
 
The institutional structure of the Indian Financial
System has undergone an outstanding
transformation.
It became more capital market oriented. This
reflected in the changes in role, organizational
policies, term lending, commercial banks, mutual
funds and so on.
In August 1991, a high level committee was
appointed under the chairmanship of Mr. M.
Narsimham (former RBI Governor) to examine all
the aspects of the financial system.
 
The committee submitted its reports in November
1991. the notable reference made were :
Privatization of Financial Institutions.
Re-organisation of existing financial structure.
Protection of Investors.
Adequacy of Capital Structure.
Review of Supervisory Arrangement.
Improve Efficiency, Effectiveness and
Competitiveness.
 
Weaknesses of Indian
Financial System
 
 
1. Government Interference
 
The Indian Financial System is all time politicised by
excessive government intervention.
The political intervention has its source in state
ownership.
This leads to virtual lack of freedom for the banks,
financial institutions, financial markets etc. to
enhance productivity and efficiency, greater
degree of autonomy should be ensured.
 
2. Lack of Professionalism
 
One of the drawback of Indian Financial System
has been caused due to unprofessional
management.
Absence of work culture, inadequate internal
controls, insufficient delegation of authority have
caused competitive inefficiency.
Professional attitude in management is very good
for performance.
 
3. Lack of Direction
 
The effectiveness of the financial system lies in
rendering efficient and timely services.
Limited delegation of authority, excessive
regulation by govt and stringent controls have
given rise to lack of direction in Indian Financial
System.
 
4. Lack of Operational flexibility
 
It is said that the functional autonomy is a pre
requisite for operational flexibility of financial
system to achieve improved performance in
terms of productivity, efficiency and profitability.
Due to tight regulation and strict controls by govt,
there is lack of operational flexibility in Indian
Financial System.
 
5. Excessive Regulation
 
One of the issues in the Indian Financial System is
that of over regulation.
If every aspect of the system is subject to control
and approval, then the financial system loses its
innovative character which obstructs the growth.
Though Indian Financial System has adopted
liberal reforms since 1991, still there are scopes to
adopt the same in other spheres.
 
6. Lack of Coordination
 
There are large numbers of participants in the
Indian Financial System.
It is characterized pre dominantly by the public
sector institution, which at times give rise to the
problem of coordination in the working of these
institutions.
 
7. Lack of Transparency
 
The banks and financial institutions adopt certain
accounting practices which do not show realistic
picture.
There is lack of transparency in such disclosures.
It raises the problem of integrity with regard to
the Indian Financial System and hampers the
financial health of the economy.
The banks make themselves more transparent
and accountable in order to gain investor
confidence.
 
Thank you
 
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The financial system plays a vital role in any economy by facilitating the flow of funds between surplus and deficit units through financial markets and intermediaries. This system involves the mobilization of savings, investments, and credit allocation, ultimately supporting economic development. Learn about the key components and functions of the financial system in this insightful discussion.


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  1. Introduction To Financial System

  2. The economic development of any nation is reflected by the progress of the various economic units, broadly classified into corporate sector, government and household sector. The units in these sector are always placed in a surplus/deficit/balanced situation, which gives rise to the process of lending and borrowing. There are units or people with surplus funds and there are those with a deficit. Surplus units refers to those who have excess funds or excess income over expenditure and wants to invest. They are known as Savers or Investors. Deficit units refers to those having lack of funds and need to borrow. They have excess expenditure over income. They are known as Borrowers.

  3. They share a mutual need of investing and borrowing by way of an financial transaction. The financial transaction is carried out at a common place known as Financial Market linked by Financial Intermediaries and thru the medium of Financial Instruments. The entire mechanism of mobilizing savings, investments and creating credit in an economy thru economic units for productive purpose is termed as Financial System. A financial system or financial sector functions as an intermediary and facilitates the flow of funds amongst the various units. People from the areas of surplus provide funds to the areas of deficit.

  4. Finance + System = Financial System Finance means monetary resources comprising ownership funds and debts. System indicates a set of interrelated parts working together to achieve some purpose. Financial System refers to mobilizing surplus funds from people and organisations and to allocate them among deficit people and organisations. An investor is an example of a Surplus Unit whereas a borrower is an example of a Deficit unit.

  5. Financial System Flow of Funds (Saving) Seekers of Funds (business firm & Govt) Suppliers of Funds (Households) Income & Financial Claims

  6. Definitions The financial system is a set of institutional arrangements thru which financial surpluses available in the economy are mobilized. The financial system consists of a variety of institutions, markets and instruments related in a systematic manner provide the principal means by which savings are transformed into investments. A financial system is a set of systematically integrated constituents which enables smooth flow of finance from areas of surplus to areas of scarcity in such a way that risk is redistributed and economic development is accelerated.

  7. Thus we can infer from the definitions that :- 1. The financial system is composed of several constituents. 2. All the constituents are related to each other. 3. These constituents come together in the system and mobilise savings. 4. Savings and the resultant investment leads to economic development.

  8. Features of the Financial System It is a composition of various institutions, markets, regulations, laws, practices, transactions, claims and liabilities. It plays a vital role in the economic development of the country. It encourages both savings and investments. It links savers and investors. It helps in capital formation. It promotes efficient allocation of financial resources for socially desirable and economically productive purposes. It facilitates expansion of financial markets. It helps in creation of financial structure that lowers the cost of transactions. 1. 2. 3. 4. 5. 6. 7. 8.

  9. Functions of Financial System

  10. 1. Payment System Financial system helps for payment of goods and services. It provides a payment system for the exchange of goods and services. We find that majority of buyers and sellers of products or services prefer to pay and receive money thru banks to avoid the risk of carrying cash in large amount. (Banks, credit cards, debit cards etc.)

  11. 2. Link between savers and investors: One of the important function of financial system is to link the savers and investors and thereby help in mobilizing and allocating the savings effectively and efficiently. For ex : A person opening savings banks account or invests money in shares it means that they are using the financial system for channeling savings into the economy.

  12. 3. Pooling of Funds Modern business organisations require large investments which are often beyond the means of an individual or groups of individuals. Financial Markets and intermediaries which are an integral part of the financial system facilitates the pooling of household savings for financing business. Thus it enables households to participate in large enterprises. Small savings are pooled together and transformed into large amounts which promoters of business can avail to meet their financial needs.

  13. 4. Transformation of savings into Capital / Investment The savings are then channelized towards entities/persons who demand finance thru the medium of equity or debt. The money thus raised is used to expand operations, start new projects etc.

  14. 5. Reduces the 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.

  15. 6. Risk Management The financial system helps to reduce the risk of savers. Financial institutions like banks and mutual funds mobilise fund from the savers and lends them to borrowers and thereby bears the risk of borrowing. For ex : When a bank uses public deposits to lend to institutions, it is passing on the funds from savers to borrowers. However if a particular borrower does not repay the bank, the bank bears the loss and does not pass on that loss to the borrower thereby redistributing the risk.

  16. 7. Economic Development By transforming savings into capital and redistributing risk, the financial system enables smooth flow of funds to productive and scarce areas. This leads to higher production and increases employment and consumer demand, accordingly more goods are available and more people are willing to purchase them.

  17. 8. Provision of Liquidity The financial system provides a mechanism for an investor to sell securities whenever there is the need for cash.

  18. Evolution of the Financial System

  19. The Indian Financial System falls into 3 different phases : Pre Independence upto 1951 Post Independence 1951 - 1990 Post 1991

  20. Pre Independence up to 1951 The structure of Indian Financial System during the Pre Independence Era was that of a traditional economy. The main features of the financial system pre 1951 was that of a closed economy consisting of : Semi organised Securities Market. Closed circle Industrial Entrepreneurship Restricted access to foreign savings Absence of financial institutions in long term industrial financing.

  21. Post Independence upto 1990s During the post independence period there has been a significant growth in the Indian Financial System in terms of quantitative indicators as well as in diversification and innovations. This period was the progressive transfer of its important constituents from private ownership to public ownership. An overview of the development of the Indian Financial System in the post independence period up to 1990 s are as under : 1. Nationalisation of Banks & Insurance Sector. 2. Developmental Banks/Institutions. 3. Investor Protection

  22. 1. Nationalization of Banks & Insurance Sector The post 1951 phase was a landmark era in the history of Indian Financial System with the nationalisation of RBI and SBI. In 1969, 14 major commercial banks were brought under direct control of government of India. The nationalisation of LIC and GIC was yet another historical measure.

  23. 2. Development Banks / Institutions In addition to nationalization, the govt created a wide range of new institutions in the public sector. The institutions were created to cater to the financial needs of industries and between them cover the whole range of Industry. The public sector occupied a commanding position in the industrial financing system in India ex ; SIDBI, IFCI, IDBI, UTI etc.

  24. 3. Investors Protection During this period, there were gross mismanagement of companies, corporate frauds and abuses which results in loss of public confidence in corporate securities market. To restore investor faith and confidence, the government adopted drastic measures such as : The Companies Act, 1956 The Capital Issues Act, 1947 Securities Contracts Act, 1956 Monopolies & Restrictive Trade practices Act, 1970 Foreign Exchange Regulation Act, 1973

  25. Post The New Industrial Policy 1991 The declaration of the New Industrial Policy witnessed a profound transformation in the Indian Financial System. The conservative philosophy of the development process in India shifted to free market economies. The notable developments in the Indian Financial System during this phase are :

  26. 1. From Public Control to Private Ownership The major steps initiated during this phase were to privatize important financial institutions. The conversion of the IFCI into a public limited company. IDBI offering their equity to private investors were all the part of privatization of financial institution. The setting up of private mutual funds and banks under the guidelines of RBI also came into existence.

  27. 2. Transformation of Institutional Structure The institutional structure of the Indian Financial System has undergone an outstanding transformation. It became more capital market oriented. This reflected in the changes in role, organizational policies, term lending, commercial banks, mutual funds and so on. In August 1991, a high level committee was appointed under the chairmanship of Mr. M. Narsimham (former RBI Governor) to examine all the aspects of the financial system.

  28. The committee submitted its reports in November 1991. the notable reference made were : Privatization of Financial Institutions. Re-organisation of existing financial structure. Protection of Investors. Adequacy of Capital Structure. Review of Supervisory Arrangement. Improve Efficiency, Effectiveness and Competitiveness.

  29. Weaknesses of Indian Financial System

  30. 1. Government Interference The Indian Financial System is all time politicised by excessive government intervention. The political intervention has its source in state ownership. This leads to virtual lack of freedom for the banks, financial institutions, financial markets etc. to enhance productivity and efficiency, greater degree of autonomy should be ensured.

  31. 2. Lack of Professionalism One of the drawback of Indian Financial System has been caused due to unprofessional management. Absence of work culture, inadequate internal controls, insufficient delegation of authority have caused competitive inefficiency. Professional attitude in management is very good for performance.

  32. 3. Lack of Direction The effectiveness of the financial system lies in rendering efficient and timely services. Limited delegation of authority, excessive regulation by govt and stringent controls have given rise to lack of direction in Indian Financial System.

  33. 4. Lack of Operational flexibility It is said that the functional autonomy is a pre requisite for operational flexibility of financial system to achieve improved performance in terms of productivity, efficiency and profitability. Due to tight regulation and strict controls by govt, there is lack of operational flexibility in Indian Financial System.

  34. 5. Excessive Regulation One of the issues in the Indian Financial System is that of over regulation. If every aspect of the system is subject to control and approval, then the financial system loses its innovative character which obstructs the growth. Though Indian Financial System has adopted liberal reforms since 1991, still there are scopes to adopt the same in other spheres.

  35. 6. Lack of Coordination There are large numbers of participants in the Indian Financial System. It is characterized pre dominantly by the public sector institution, which at times give rise to the problem of coordination in the working of these institutions.

  36. 7. Lack of Transparency The banks and financial institutions adopt certain accounting practices which do not show realistic picture. There is lack of transparency in such disclosures. It raises the problem of integrity with regard to the Indian Financial System and hampers the financial health of the economy. The banks make themselves more transparent and accountable in order to gain investor confidence.

  37. Thank you

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