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Financial system and its components
Meaning of Financial System
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A Financial system is a network of financial institutions, financial markets, financial
instruments, and financial services to facilitate the transfer and allocation of funds efficiently
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It helps to transfer funds from individual and groups who save money to individuals and group
who want to borrow money
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It gives investors the ability to grow their wealth and assets
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These savings are then channelized by lending to
various business concerns which are involved in production and distribution
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Financial institutions, such as banks, facilitate this process by
accepting deposits from savers and providing loans or credit to borrowers
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It allows individuals and
businesses to access capital for various purposes, such as investments, entrepreneurship, or
consumption
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This includes
payment systems, electronic funds transfers, and various mechanisms, checks, credit cards etc
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Structure of Financial System
In most of the developing countries like India there is co-existence & co-operation between the
organised/formal &unorganised/informal financial sectors
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Difference between organised and unorganised financial system
In the organized financial system, institutions operate within a formal regulatory framework, such
as banks, stock exchanges, and financial intermediaries
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The organized system tends to be more extensive,
providing a range of financial products and services to a diverse population
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On the other hand, the unorganized financial system comprises informal entities that operate with
no regulatory scrutiny
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The unorganized system may lack
the formal structures and regulatory oversight found in the organized sector, making it riskier
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Informal Financial System
Components of Unorganised financial system
1) Moneylenders
They are classified into two categories: (a) The professional moneylenders are those whose
primary business is moneylending
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The main function
of moneylenders is to give short-term loans
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Loans are generally given on the
personal security of borrowers and charge very high interest rates
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They accept
valuables of customers for safe custody
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They are the major sources of funds for small
borrowers on account of simple documentation
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It is known as chit fund because
at the end of each month a lot is taken out and whose name comes in the lot/chit gets the entire
money for the month
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It is a
borrowing cum savings instrument
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There are over 10,000 registered chit funds in India
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Mostly items of personal property are used as collateral like gold, silver, musical instruments,
coins, computers etc
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The
duration of loan the and rate of interest decided by the pawnbrokers
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5) Jewellers
The gold loan market in India is dominated by jewellers
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There is no fixed rate of interest,
tenure or documentation required for borrowing funds against gold
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No certificate is issued for
pledging the gold
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6) Traders and Commission Agents
This is commonly observed in rural area where farming is largely practiced
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Organised Market in India
Types of loans granted by financial institutions
1) Secured loans
When the loan is taken by pledging a particular asset as a collateral, then such loan is termed as
secured loan
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The collateral is always of higher
value than the loan granted
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Home loans
Home loans are taken for the purchase or construction of a home by the borrower
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Gold loans
Gold acts as a security for the lender
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2) Unsecured loans
When the loan is taken without pledging a particular asset as a collateral, then it is called as
unsecured loans Such loans are not secured against any asset of the borrower
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Personal loans
It is essentially a loan against the income of the borrower
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In such
cases, an education loan provides monetary assistance
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These are further divided into:
1) Money market: It refers to the institutional arrangement facilitating borrowing and lending
of short-term funds for periods varying from a day to 1 year
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Call
money market, Certificate of deposit, Commercial paper and Treasury bills are the major
instruments of the money market
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It mobilises long term savings to finance long term investments
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Secondary capital market/ stock market deals with trading in existing securities
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It helps to determine exchange rates of different foreign currencies
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Regulators of the Indian Financial Market
1) Central Govt
The foremost important regulator of the financial sector in the country is the central government
and Ministry of Finance
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RBI itself receives directions from Ministry of Finance to
take various decisions pertaining to the financial aspects of an economy
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The RBI is given wide powers of
monetary policy making, supervising, and controlling the commercial, cooperative, nationalised,
rural and regional banks in India
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3) Securities & Exchange Board of India (SEBI)
The SEBI is an apex body that looks after the regulation of the securities market in India
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➢ Identifying and prohibiting insider trading and unfair trade practices
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The PFRDA was established in August 2003 and is headquartered
in New Delhi
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The PFRDA regulates the pension schemes such as the Atal
Pension Yojana and NPS
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Its headquarters are situated in Hyderabad
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It is a non-profit organization
that ensures the smooth functioning of the mutual fund industry by implementing high ethical
standards and protects the interests of both – the fund houses and investors
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It oversees the various
institutions, working towards promoting financial inclusion, stability, and efficiency in the sector
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However, in
2015, FMC was merged with SEBI to modernize regulatory functions
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Financial Institutions
Financial institutions are intermediaries that mobilise savings and facilitate the allocation of
funds in an efficient manner
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Financial Institutions have 2 major types:
a
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Interests are paid on these deposits made by the
people
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Interests are charged on
these loans given to those who require it
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b
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These
are based on offering insurance, mutual funds, brokerage deals, etc
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, venture capital co
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, factoring co
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These further have 3 categories:
i
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iii
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Example – RBI, IRDA, SEBI, etc
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Example – PNB, SBI, HDFC, BOB, Axis Bank
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Examples – NABARD, SIDBI, etc
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Individuals who make deposits are offered a variety of
tools to help them secure their cash and also to help them access it at any time
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2) Loans
Financial intermediaries are primarily engaged in advancing short- and long-term loan facilities
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Intermediaries advance the loans at interest, with a portion of the money going
to the depositors whose funds have been utilized to make the loans
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3) Investments
Clients of financial intermediaries such as mutual funds and investment banks may benefit from
the expertise of in-house investment professionals who assist them in growing their investments
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Financial Instruments/ Assets
Investment in the financial market is facilitated by financial instruments
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Financial instruments
carry a monetary value and are legally enforceable
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2) Debt-Based Instruments: These are financial contracts where an entity borrows money from
an investor and promises to repay the amount borrowed, typically with periodic interest
payments like bonds, debentures
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Example: Bank deposits
4) Primary securities are the instruments/assets issued for the first time in the primary market
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Equity shares, preference shares, bonds and
debentures
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, bank deposits, mutual fund units and insurance policies
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6) Another category of financial assets is derivatives-most used are forward contract, future
contracts, and options
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The finance industry includes
a number of organizations that deal with money
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banks, credit card companies, insurance
companies, stock brokerages etc
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1) Banking Services: These include basic services like savings and checking accounts, credit
facilities (loans, mortgages), and other banking products offered by commercial banks, credit
unions, and online banks
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3) Financial Planning and Advisory Services: Financial advisors and planners offer guidance
on financial planning, retirement planning, budgeting, and investment strategies tailored to
individual or business financial goals
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Role of Financial system in the economic development of a country
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Here, the role of financial institutions is important, since they induce the public
to save by offering attractive interest rates
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Companies are able to
raise long term funds through issue of shares, debentures in capital market, while financial
institutions arrange short term funds in the money market leading to growth of both the markets
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Growth of infrastructure
With the policy of economic liberalisation, more private sector industries have come forward to
start infrastructure industry
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Development banks
provide helping hand for private sector firms in raising huge capital that is required to finance the
infrastructural projects like construction of roads, bridges etc
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Helps in development of Trade
The financial system helps in the promotion of both domestic and foreign trade
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Foreign trade is promoted due to pre shipment and post shipment finance by
commercial banks and of issue letter of credit in favour of the importer
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Employment growth is boosted
Financial system provides fixed and working capital to the businessmen and manufacturers, due
to which production increases resulting in generating more employment opportunities
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Various financial services such as leasing, factoring, merchant
banking, etc, will also generate more employment
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Venture capital
The economic development of a country will be rapid when more ventures are promoted, which
require modern technology and venture capital
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It is only through financial system; more financial institutions
will contribute a part of their investable funds for the promotion of new ventures
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Balanced regional development
Through the financial system, backward areas could be developed by providing various
concessions
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It will also check migration of rural
population towards towns and cities
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Balanced economic growth
The growth of different sectors of an economy is balanced through the financial system
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Flow of Fund Matrix
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The flow of funds accounts was developed by Prof
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The flow of funds accounts lists the sources of all funds received and the uses to which they
are put within the economy
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The FoF accounts divide the economy into five institutional sectors namely: 1
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Non- Financial Corporate Sector
3
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Households
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Rest of the World (RoW)
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If the borrowing is more than the lending, the sector
is termed as a deficit sector
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The flow of funds accounting system is presented in the form of a matrix by placing sources
and uses of funds statements of different sectors side by side
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Economy-wise, total savings must equal total investment
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Hence a
column is added as a balancing entry
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It shows the pattern of financing economic activities and the financial inter- relationship among
various sectors of the economy
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Identifies the role of financial institutions in the generation of income, saving and expenditure
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By looking at the historical flow of funds, emerging trends in the economy and changes in
financial pattern can be tracked
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It shows how the government finances its deficit and surplus budget and acquires financial
assets
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It helps in analysing the impact of monetary policies on the economy as to whether they bring
stability or instability
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They are an important tool for financial planning and forecasting
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Since detail micro-level data is not available, data are collected using samples and then generate
aggregate figures for each sector
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Since these flows are estimated, they may not tally with other published data
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The flow of funds accounts are more complicated than the national income accounts because
they involve the aggregation of many sectors with their very detailed financial transactions
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There is the problem of valuation of assets
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It, therefore, becomes difficult to have their correct valuation
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Similarly, economists have failed to decide about the inclusion of human wealth in flow of funds
accounts
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Theoretically, total sources and total uses should balance
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