Module - 4: Introduction to Financial Services

Structure

4.1 : Meaning of Financial Services .................................................................................. 70

4.2 : Features of Financial Services ................................................................................... 71
4.3 : Scope of Financial Services....................................................................................... 72
4.3.1 : Asset / Fund based Services ..................................................................................... 72
4.3.2 : Non-Fund Based/Fee Based Financial Services .................................................... 75
4.4 : Challenges faced by the financial service sector....................................................... 77

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5. Explain the Challenges faced by the financial service sector.
........................................................................................................................................... 78

a. Suggested Readings / Reference Books ....................................................................... 78

Learning Objectives

4.1 : Meaning of Financial Services

In general, all types of activities which are of financial nature may be regarded as financial
services. In a broad sense, the term financial services mean mobilization and allocation of
savings. Thus, it includes all activities involved in the transformation of savings into
investment.

Financial services refer to services provided by the finance industry. The finance industry
consists of a broad range of organizations that deal with the management of money. These
organizations include banks, credit card companies, insurance companies, consumer finance
companies, stock brokers, investment funds and some government sponsored enterprises.
Financial services may be defined as the products and services offered by financial
institutions
for the facilitation of various financial transactions and other related activities.

Financial services can also be called financial intermediation. Financial intermediation is a

process by which funds are mobilized from a large number of savers and make them
available to all those who are in need of it and particularly to corporate customers. There are
various institutions which render financial services. Some of the institutions are banks,
investment companies, accounting firms, financial institutions, merchant banks, leasing
companies, venture capital companies, factoring companies, mutual funds etc. These
institutions provide variety of services to corporate enterprises. Such services are called
financial services. Thus, services rendered by financial service organizations to industrial
enterprises and to ultimate consumer markets are called financial services. These are the
services and facilities required for the smooth operation of the financial markets. In short,
services provided by financial intermediaries are called financial services.
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The Indian financial services industry has undergone a metamorphosis since1990. Before its
emergence the commercial banks and other financial institutions dominated the field and they
met the financial needs of the Indian industry. It was only after the economic liberalization
that the financial service sector gained some prominence. Now this sector has developed into
an industry.

In fact, one of the world’s largest industries today is the financial services industry.
Financial service is an essential segment of financial system. Financial services are the
foundation of a modern economy. The financial service sector is indispensable for the
prosperity of a nation.

4.2 : Features of Financial Services

From the following characteristics of financial services, we can understand their nature:

1. Intangibility: Financial services are intangible. Therefore, they cannot be standardized

or reproduced in the same form. The institutions supplying the financial services should
have a better image and confidence of the customers. Otherwise, they may not succeed.
They have to focus on quality and innovation of their services. Then only they can
build credibility and gain the trust of the customers.
2. Inseparability: Both production and supply of financial services have to be performed
simultaneously. Hence, there should be perfect understanding between the financial
service institutions and its customers.
3. Perishability: Like other services, financial services also require a match between
demand and supply. Services cannot be stored. They have to be supplied when
customers need them.
4. Variability: In order to cater a variety of financial and related needs of different
customers in different areas, financial service organizations have to offer a wide range
of products and services. This means the financial services have to be tailor-made to the
requirements of customers. The service institutions differentiate their services to
develop their individual identity.
5. Dominance of human element: Financial services are dominated by human element.

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 Thus, financial services are labor intensive It requires competent and skilled personnel
to market the quality financial products.
6. Information based: Financial service industry is an information based industry. It
involves creation, dissemination and use of information. Information is an essential
component in the production of financial services.

4.3 : Scope of Financial Services

The scope of financial services is very wide. This is because it covers a wide range of
services. The financial services can be broadly classified into two:
(a) fund based services and
(b) non-fund services or fee-based services

4.3.1 : Asset / Fund based Services

1. Equipment leasing/Lease financing: A lease is an agreement under which a firm

acquires a right to make use of a capital asset like machinery etc. on payment of an
agreed fee called lease rentals. The person (or the company) which acquires the right
is known as lessee. He does not get the ownership of the asset. He acquires only the
right to use the asset. The person (or the company) who gives the right is known as
lessor.

2. Hire purchase and consumer credit: Hire purchase is an alternative to leasing. Hire
purchase is a transaction where goods are purchased and sold on the condition that
payment is made in instalments. The buyer gets only possession of goods. He does not
get ownership. He gets ownership only after the payment of the last instalment. If the
buyer fails to pay any instalment, the seller can repossess the goods. Each instalment
includes interest also.

3. Bill discounting: Discounting of bill is an attractive fund based financial service

provided by the finance companies. In the case of time bill (payable after a specified
period), the holder need not wait till maturity or due date. If he is in need of money,
he can discount the bill with his banker. After deducting a certain amount (discount),
the banker credits the net amount in the customer’s account. Thus, the bank purchases

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 the bill and credits the customer’s account with the amount of the bill less discount.
On the due date, the drawee makes payment to the banker. If he fails to make
payment, the banker will recover the amount from the customer who has discounted
the bill. In short, discounting of bill means giving loans on the basis of the security of
a bill of exchange.

4. Venture capital: Venture capital simply refers to capital which is available for
financing the new business ventures. It involves lending finance to the growing
companies. It is the investment in a highly risky project with the objective of earning
a high rate of return. In short, venture capital means long term risk capital in the form
of equity finance.

5. Housing finance: Housing finance simply refers to providing finance for house
building. It emerged as a fund based financial service in India with the establishment
of National Housing Bank (NHB) by the RBI in 1988. It is an apex housing finance
institution in the country. Till now, a number of specialized financial
institutions/companies have entered in the field of housing finance. Some of the
institutions are HDFC, LIC Housing Finance, Citi Home, Ind Bank Housing etc

6. Insurance services: Insurance is a contract between two parties. One party is the
insured and the other party is the insurer. Insured is the person whose life or property
is insured with the insurer. That is, the person whose risk is insured is called insured.
Insurer is the insurance company to whom risk is transferred by the insured. That is,
the person who insures the risk of insured is called insurer. Thus insurance is a
contract between insurer and insured. It is a contract in which the insurance company
undertakes to indemnify the insured on the happening of certain event for a payment
of consideration. It is a contract between the insurer and insured under which the
insurer undertakes to compensate the insured for the loss arising from the risk insured
against.

According to Mc Gill, “Insurance is a process in which uncertainties are made

certain”. In the words of Jon Megi, “Insurance is a plan wherein persons collectively
share the losses of risks”. Thus, insurance is a device by which a loss likely to be

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 caused by uncertain event is spread over a large number of persons who are exposed
to it and who voluntarily join themselves against such an event. The document which
contains all the terms and conditions of insurance (i.e. the written contract) is called
the ‘insurance policy’. The amount for which the insurance policy is taken is called
‘sum assured’. The consideration in return for which the insurer agrees to make good
the loss is known as ‘insurance premium’. This premium is to be paid regularly by the
insured. It may be paid monthly, quarterly, half yearly or yearly.

7. Factoring: Factoring is an arrangement under which the factor purchases the account
receivables (arising out of credit sale of goods/services) and makes immediate cash
payment to the supplier or creditor. Thus, it is an arrangement in which the account
receivables of a firm (client) are purchased by a financial institution or banker. Thus,
the factor provides finance to the client (supplier) in respect of account receivables.
The factor undertakes the responsibility of collecting the account receivables. The
financial institution (factor) undertakes the risk. For this type of service as well as for
the interest, the factor charges a fee for the intervening period. This fee or charge is
called factorage.

8. Forfaiting: Forfaiting is a form of financing of receivables relating to international

trade. It is a non-recourse purchase by a banker or any other financial institution of
receivables arising from export of goods and services. The exporter surrenders his
right to the forfeiter to receive future payment from the buyer to whom goods have
been supplied. Forfaiting is a technique that helps the exporter sells his goods on
credit and yet receives the cash well before the due date. In short, forfaiting is a
technique by which a forfeiter (financing agency) discounts an export bill and pay
ready cash to the exporter. The exporter need not bother about collection of export
bill. He can just concentrate on export trade.

9. Mutual fund: Mutual funds are financial intermediaries which mobilize savings from
the people and invest them in a mix of corporate and government securities. The
mutual fund operators actively manage this portfolio of securities and earn income
through dividend, interest and capital gains. The incomes are eventually passed on to
mutual fund shareholders.

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 4.3.2 : Non-Fund Based/Fee Based Financial Services

Today, customers are not satisfied with mere provision of finance. They expect more from
financial service companies. Hence, the financial service companies or financial
intermediaries
provide services on the basis of non-fund activities also. Such services are also known as fee
based services.

The most important fund based and non-fund based services (or types of services) may be
briefly discussed as below:

1. Merchant banking: Merchant banking is basically a service banking, concerned with

providing non-fund based services of arranging funds rather than providing them. The
merchant banker merely acts as an intermediary. Its main job is to transfer capital
from those who own it to those who need it. Today, merchant banker acts as an
institution which understands the requirements of the promoters on the one hand and
financial institutions, banks, stock exchange and money markets on the other. SEBI
(Merchant Bankers) Rule, 1992 has defined a merchant banker as, “any person who is
engaged in the business of issue management either by making arrangements
regarding selling, buying or subscribing to securities or acting as manager, consultant,
advisor, or rendering corporate advisory services in relation to such issue
management”.

2. Credit rating: Credit rating means giving an expert opinion by a rating agency on the
relative willingness and ability of the issuer of a debt instrument to meet the financial
obligations in time and in full. It measures the relative risk of an issuer’s ability and
willingness to repay both interest and principal over the period of the rated
instrument. It is a judgement about a firm’s financial and business prospects. In short,
credit rating means assessing the creditworthiness of a company by an independent
organization.

3. Stock broking: Now stock broking has emerged as a professional advisory service.

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 Stock broker is a member of a recognized stock exchange. He buys, sells, or deals in
shares/securities. It is compulsory for each stock broker to get himself/herself
registered with SEBI in order to act as a broker. As a member of a stock exchange, he
will have to abide by its rules, regulations and bylaws.

4. Custodial services: In simple words, the services provided by a custodian are known
as custodial services (custodian services). Custodian is an institution or a person who
is handed over securities by the security owners for safe custody. Custodian is a
caretaker of a public property or securities. Custodians are intermediaries between
companies and clients (i.e. security holders) and institutions (financial institutions and
mutual funds). There is an arrangement and agreement between custodian and real
owners of securities or properties to act as custodians of those who hand over it. The
duty of a custodian is to keep the securities or documents under safe custody. The
work of custodian is very risky and costly in nature. For rendering these services, he
gets a remuneration called custodial charges. Thus custodial service is the service of
keeping the securities safe for and on behalf of somebody else for a remuneration
called custodial charges.

5. Loan syndication: Loan syndication is an arrangement where a group of banks

participate to provide funds for a single loan. In a loan syndication, a group of banks
comprising 10 to 30 banks participate to provide funds wherein one of the banks is the
lead manager. This lead bank is decided by the corporate enterprises, depending on
confidence in the lead manager. A single bank cannot give a huge loan. Hence a
number of banks join together and form a syndicate. This is known as loan
syndication. Thus, loan syndication is very similar to consortium financing.

6. Securitization of debt: Loans given to customers are assets for the bank. They are
called loan assets. Unlike investment assets, loan assets are not tradable and
transferable. Thus loan assets are not liquid. The problem is how to make the loan of a
bank liquid. This problem can be solved by transforming the loans into marketable
securities. Now loans become liquid. They get the characteristic of marketability. This
is done through the process of securitization. Securitization is a financial innovation.
It is conversion of existing or future cash flows into marketable securities that can be

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 sold to investors. It is the process by which financial assets such as loan receivables,
credit card balances, hire purchase debtors, lease receivables, trade debtors etc. are
transformed into securities. Thus, any asset with predictable cash flows can be
securitized.
Securitization is defined as a process of transformation of illiquid asset into security
which may be traded later in the opening market. In short, securitization is the
transformation of illiquid, non- marketable assets into securities which are liquid and
marketable assets. It is a process of transformation of assets of a lending institution
into negotiable instruments.
7. Securitization is different from factoring. Factoring involves transfer of debts without
transforming debts into marketable securities. But securitization always involves
transformation of illiquid assets into liquid assets that can be sold to investors.

4.4 : Challenges faced by the financial service sector.

Financial service sector has to face lot of challenges in its way to fulfil the ever growing
financial demand of the economy. Some of the important challenges are listed below:
1. Lack of qualified personnel in the financial service sector.
2. Lack of investor awareness about the various financial services.
3. Lack of transparency in the disclosure requirements and accounting practices relating
to financial services.
4. Lack of specialization in different financial services (specialization only in one or two
services).
5. Lack of adequate data to take financial service related decisions.
6. Lack of efficient risk management system in the financial service sector.

The above challenges are likely to increase in number with the growing requirements of the
customers. However, the financial system in India at present is in a process of rapid
transformation, particularly after the introduction of new economic reforms.

Test your understanding

1. Define financial services

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 2. Explain the features of financial services
3. Describe the scope of financial services
4. Write a note on:
a. Asset / Fund based Services
b. Non-Fund Based/Fee Based Financial Services
5. Explain the Challenges faced by the financial service sector.

a. Suggested Readings / Reference Books:

1. E. Gordon and K. Natarajan – Financial markets and services –Himalaya
publications
2. Vasant Desai – Indian financial system –Himalaya publications.
3. LM Bhole – Financial institutions and market –Tata McGraw Hill.
4. YM. Khan – Financial services –Tata McGraw Hill
5. Financial Markets Institutions and Services by Taxmann

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