Indian Financial System Notes PDF

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Indian Financial System Notes Important Questions 1. Chapter 1 a. Characteristics of Financial Systems b. Functions of Financial Markets c. Primary Market d. Secondary Market e. Capital Market 2. Net Asset Value and Expense Ratio 3. Mutual Funds and it’s benefits 4. Characteristics of public financial system 5. Asset Management Company 6. Money Market 7. How the RBI maintains exchange rates 8. Public and private sector banks 9. Objectives and Functions of SEBI (Tomorrow) Chapter 1: Introduction to Financial System  

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Financial system is a group of integrated sub-grounds consisting of financial markets, financial instruments, financial services and financial institutions. Financial Institutions: Mobilize savings and facilitate the efficient allocation of funds o Classification of financial markets:  Banking (creators and purveyors of credit) and non-banking (purveyors of credit) (DFIs, Housing Finance, NBFCs)  Term finance (IDBI, SIDBI, IFCI, ICICI)  Investment (LIC, Unit Trust of India)  Sectoral (NABARD)  Specialized (EXIM)  State Level (State Finance Corporations and State Industrial Development Corporations) Financial Markets: Provide a mechanism through which participants can deal in financial claims o Types of financial markets:  Money Market (short-term securities, 1 year, regulated by SEBI) o Segments of financial markets:  Primary Market (new issues)  Secondary Market (trading based on existing or outstanding securities)  Over The Counter Market (government securities, fast delivery, on the spot returns)  Exchange-Traded Market (trading based on the trade cycle of stock exchange, derivatives markets) Financial Instruments: A claim against a person or an institution for a payment, set in the future, for a sum of money paid in the form of interest or dividend

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o Types of Securities  Primary  Secondary o Distinct features of financial instruments  Marketable: Denominated in small amounts and traded in organized markets  Tradable: Primary and Secondary  Tailor made (for savers and borrowers) Financial Services o Categories:  Funds Intermediation: act as link between borrower and saver  Provision of liquidity: Smooth running of financial system  Risk management: risk transfer or protection risk  Financial engineering: presents opportunities for value creation o Need for Financial Services:  Borrowing and funding  Investing and lending  Payments and settlements  Managing risk  Payment and settlement  Buying and selling of securities Interaction among financial system components: o The components don’t work in isolation o They are interdependent and interact continuously with each other o This enables the smooth functioning of the financial system o Have close links with the financial markets in the economy o Financial intermediaries rely on financial markets when they want to raise funds. This increases competition between the intermediaries to attract investors. Functions of the Financial System o Mobilize and allocate savings o Monitor corporate performance (threat for underperforming firms through hostile takeovers) o Provide payment and settlement systems (ensures funds move safely, quickly and in a timely manner) o Optimum allocation of risk bearing and risk reduction (holding diversified portfolios reduces risk, trading in derivatives shifts risk from those who have it to those who are willing to take it) o Disseminate price related information (helps make informed investment decisions) o Offer portfolio adjustment facility (handled by intermediaries and markets, provide a quick, cheap and reliable way of buying and selling a wide range of financial assets) o Lower the cost of transactions (encourages saving which is used for investing)

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o Promote the process of financial deepening (increasing financial assets as a percentage of the GDP) and broadening (increasing the number and variety of financial participants) Key elements of a well-functioning financial system: o Strong legal and regulatory environment (protects investors from scams) o Stable money (fluctuations can lead to a financial crisis) o Sound public finances and debt management  Banker to banks  Banker to government  Manager of public debt  Manager of foreign exchange  Lender of last resort o A central bank (supervises and regulates the banking system) o Sound banking system (should be able to handle sudden changes and work efficiently) o Information system (proper disclosure practices help develop financial system) o Well-functioning securities market (promote economic growth by mobilizing funds and lowering the cost of capital, providing liquidity and attracting foreign investment) Financial System Designs o Bank-based: few major banks play a dominant role and the stock market isn’t important (Germany) o Market-based: financial markets play an important role while the banking industry is much less concentrated (USA) Characteristics of Financial Markets o Large volume of transactions and the speed with which financial resources move from one market to another o Various segments of financial markets such as stock markets, bond markets (primary and secondary) where savers themselves decide when and where they should invest their money o Scope for instant arbitrage among various markets and types of instruments o Highly volatile and susceptible to panic and distress selling as the behavior of a small group gets generalized o Markets are dominated by financial intermediaries who take investment decisions as well as risks on behalf of their depositors. o Negative externalities are associated with financial markets. o Domestic financial markets are getting integrated with worldwide financial markets. Functions of Financial Markets o Enabling economic units to exercise their time preference o Separation, distribution, diversification and reduction of risk o Efficient payment mechanism o Providing information about companies o Transmutation or transformation of financial claims to suit the preferences of both savers and borrowers

o Enhancing liquidity of financial claims through securities o Providing portfolio management services Chapter 4: The Money Market   

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Market for financial assets that are close substitutes for money Market for overnight to short-term funds and instruments having a maturity period of less than one year Characteristics of Money Market: o Not a single market but a collection of markets for several instruments o Wholesale market of short-term debt instruments o Principle feature is honor where the creditworthiness of a participant is important o Main players are RBI, Discount and Finance House of India, Mutual Funds, Insurance Companies Banks, Corporate Investors, NBFCs, state governments, provident funds, Securities Trading Corporation of India, non-resident Indians, public sector undertakings etc. o Need-based market wherein demand and supply of money shape the market o Transactions can be both secured and unsecured Four broad Functions of the Money Market o Provides a balancing technique to even out the demand and supply of shortterm funds o Provides a focal point for the central bank intervention for influencing liquidity and general level of interest rates in the economy o Provides a reasonable access to suppliers and users of short-term funds to fulfil their borrowing and investment requirements at an efficient market clearing price o Plays a central role in the monetary policy transmission mechanism as through it, the operations of monetary policy are transmitted to financial markets and ultimately to the real economy Benefits of an efficient money market o Provides a stable source of funds to banks o Encourages development of non-bank entities o Facilitates government market borrowing o Makes effective monetary policy actions o Helps in pricing different floating interest products Money Market Instruments o Treasury Bills  Short-term instruments used by the government to raise short-term funds  Issued by RBI o Cash Management Bills  RBI on behalf of the government issues a new short-term instrument to meet the temporary mismatch in the cash flow of the government o Call/notice money market

Call money is required by banks (for CRR). Funds are transacted overnight  Notice money: funds are borrowed/lent for a period b/w 2-14 days Commercial Papers  Commercial Paper is an unsecured short-term promissory note issued at discount Certificates of Deposits  Short-term tradeable time-deposits issued by commercial banks and financial institutions Commercial Bills  Negotiable instruments drawn by the seller on the buyer which are accepted and discounted by commercial banks Collateralized borrowing and lending obligation 

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Mutual Funds and it’s benefits    

A mutual fund serves as a link between the investor and the securities market by mobilizing savings from the investor and the securities market to generate returns. A mutual fund is a financial intermediary that pools the savings of investors for a collective investment in a diversified portfolio of securities Its returns are shared by its investors Benefits of Mutual Funds o Professional management: managed by professionals who make the best choices with your funds, they have the skills and expertise and can create an organized investment strategy o Portfolio diversification: diversification reduces risk per investor o Reduction in transaction cost: Investing through the fund is less expensive o Liquidity: Mutual funds can easily be liquidated by selling the units (openended scheme) or selling on the stock exchange (close-ended scheme) o Convenience: reduces paperwork, saves time and makes it easy o Flexibility: Varied types of schemes o Tax benefits o Transparency: Investor knows what’s happening with his/her money o Stability to the stock market: can absorb any losses and shocks in the stock market o Equity Research: mutual funds can afford information and data required for investment due to large amount of funds o Protection of interest of investors: Regulated by SEBI

Net Asset Value and Expense Ratio    

Net asset value of a mutual fund is the market value of the assets minus the liabilities on the day of valuation. Amount that shareholders will collectively get if the fund is liquidated or dissolved NAV of a unit of mutual funds is NAV/number of outstanding units NAV = (Market price of securities + other assets – total liabilities)/units outstanding as at the NAV date

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NAV is the price at which an investor can buy or sell a unit of a mutual fund schemes NAVs are disclosed on a daily basis in case of open-ended schemes and weekly in the case of close-ended schemes Expense Ratio is the ratio of expenses incurred by a mutual fund for managing a fund to net assets of the fund It represents the proportion of the fund’s assets that go towards the expenses of running the fund The expenses include management fees, administrative costs, commission etc. Expensive ratio is the cost of owning a fund whereas the load is the cost of buying a fund Expense ratio is disclosed every six months

Asset Management Company       

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Trustees appoint AMC with prior approval of SEBI using an investment management agreement AMC is formed and registered under the companies act, 2013 to manage the affairs of the mutual fund and operate the schemes of such mutual funds Acts as an investment manager to the mutual fund AMC should be registered with SEBI AMC of mutual fund should have a net worth of 50 Crores at all times and this net worth should be in the form of cash Most AMCs are private limited companies Three key players namely the sponsor, the mutual fund trust and the asset management company (AMC) are involved in setting up a mutual fund. They are assisted by independent administrative entities like banks, registrars, transfer agents and custodians (Depository participants). AMC is in the name of a trust, floats and then manages the different investment schemes as per SEBI regulation Example: HDFC AMC Obligations of AMC: o Ensure that the investment of funds in any scheme conforms with the regulations and the Trust Deed o Exercise due diligence and care in investment decisions o Submit quarterly report on its activities and compliance with regulation to the trustees o Maintain proper accounts and records for each scheme o Be registered with SEBI

How RBI manages exchange rate The RBI adopts too suitable measures to attain this objective. The exchange control system is one such measure. Under exchange control system, every citizen of India has to deposit with the RBI all foreign currency or exchange that he/she receives. And whatever foreign exchange he might need has to be secured from the RBI by making an application in the prescribed form. The central bank also keeps gold and bullion reserves....