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Chapter 1
Financial system: An
Introduction
Indian Financial System, 5e
By: Bharati V. Pathak
Figure 1.1
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By: Bharati V. Pathak
Indian Financial System, 5e
Chapter Objectives
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To understand:
1. Meaning of Financial system.
2. Components of the Financial system.
3. Functions of the Financial System.
4. Key elements of the Financial System.
5. Key elements of a well functioning financial system.
6. Bank- based and Market- based financial systems.
7. Nature and role of Financial Institutions and Markets.
8. Link between Money market and Capital market.
9. Link between Primary market and Secondary market
10.Functions and Characteristics of Financial markets.
Indian Financial System, 5e
By: Bharati V. Pathak
Meaning of Financial System
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A set of sub systems of financial institutions,
markets, instruments and services.
Intermediates with the flow of funds between
savers and borrowers.
Facilitates transfer and allocation of scarce
resources efficiently and effectively.
Indian Financial System, 5e
By: Bharati V. Pathak
Types of Financial System
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•Formal financial system
• Organized, institutional and regulated
•Informal financial system
• Advantages: Low transaction costs,
Minimum default risk and Transparency
of procedures
• Disadvantages: Wide range of interest
rates, Higher rates of interest and
Unregulated
Indian Financial System, 5e
By: Bharati V. Pathak
Components of the Financial
System
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•Financial Institutions
•Financial Markets
•Financial Instruments
•Financial Services
Indian Financial System, 5e
By: Bharati V. Pathak
Types of Financial Institutions
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Banking and Non–Banking
Banking: creators and purveyors of credit.
Types: Commercial Banks & Cooperative
Banks
Non-Banking: purveyors of credit
Types: Developmental financial institutions;
Mutual Funds; Insurance companies and
NBFCs
Indian Financial System, 5e
By: Bharati V. Pathak
Functions of Financial Institutions
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Provide three transformation services:
Liability, asset and size transformation
Maturity transformation
Risk transformation
Indian Financial System, 5e
By: Bharati V. Pathak
Financial Markets
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Types: Money Market – A market for short –term debt
instruments.
Capital Market - A market for long -term equity and
debt instruments
Segments: Primary Market – A market for new issues
Secondary Market – A market for tradin outstanding issues
Indian Financial System, 5e
By: Bharati V. Pathak
Link Between Primary and
Secondary Capital Market
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A buoyant secondary market indispensable
for the presence of a vibrant primary
market
Secondary market provides a basis for the
determination of prices of new issues
Depth of the secondary market depends on
the primary market
Bunching of new issues affects prices in the
secondary market
Indian Financial System, 5e
By: Bharati V. Pathak
Financial Services
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Major categories : Funds Intermediation
Payments Mechanism
Provision of liquidity
Risk Management
Financial Engineering
Indian Financial System, 5e
By: Bharati V. Pathak
Functions of Financial System
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Mobilise and allocate savings
Monitor corporate performance
Provide payment and settlement systems
Optimum allocation of risk bearing and reduction
Disseminate prize related information
Offer portfolio adjustment facility
Lower the cost of transactions
Promote the process of financial deepening and
broadening
Indian Financial System, 5e
By: Bharati V. Pathak
Key Elements of a Well -
functioning Financial System
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A strong legal and regulatory environment
Stable money
Sound public finances and public debt
management
A central bank
Sound banking system
Information system
Well -functioning securities market
Indian Financial System, 5e
By: Bharati V. Pathak
Financial System Designs
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Types: Bank–based & Market–based
Indian Financial System, 5e
By: Bharati V. Pathak
Market-based Financial System
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Advantages:
Provide attractive terms to both investors and borrowers
Facilitate diversification
Allow risk sharing
Allow financing of new technologies
Drawbacks:
Prone to instability
Exposure to market risk
Free rider problem
Indian Financial System, 5e
By: Bharati V. Pathak
Bank–based Financial System
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Advantages:
Close relationships with parties
Provide tailor made contracts
Efficient inter-temporal risk sharing
No free rider problem
Drawbacks:
Retards innovation and growth
Impedes competition
Indian Financial System, 5e
By: Bharati V. Pathak
Functions of Financial Markets
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Enabling economic units to exercise their time
preference
Seperation, distribution, diversification and
reduction of risk
Efficient payment mechanism
Providing information
Enhancing liquidity
Providing portfolio management services.
Indian Financial System, 5e
By: Bharati V. Pathak
