Understanding the Financial System: Key Components and Functions

A financial system is the network of institutions, markets, instruments, and services that facilitates the transfer and allocation of funds between savers and borrowers, fostering economic growth. It plays a critical role by mobilizing savings, allocating resources efficiently, managing risks, and providing liquidity to support productive investment.

Meaning

The financial system connects those with surplus funds to those in need of funds, ensuring smooth monetary exchanges and supporting broader economic activity.

Importance

It mobilizes individual and institutional savings, channels them into investments, enables risk management through insurance and derivatives, provides a payment mechanism, and supports economic stability and development.

Functions

• Mobilization of savings from households, businesses, and government
• Allocation of credit to productive sectors
• Providing payment and settlement systems for economic transactions
• Risk management through insurance and derivatives
• Price discovery for financial assets via markets

Structure

The financial system includes:

• Financial Markets: Such as stock markets, bond markets, and money markets where financial assets are traded.
• Financial Institutions: Banks, non-banking financial companies (NBFCs), insurance companies, mutual funds, and pension funds act as intermediaries.
• Financial Instruments: Stocks, bonds, derivatives, and insurance contracts that facilitate investment, borrowing, and risk management.
• Financial Services: Asset management, credit provision, advisory, payment processing, and insurance services supporting the financial ecosystem.

The Indian money market is structured into three major sectors: the Organised Sector, the Co-operative Sector, and the Unorganised Sector.

Organised Sector

This sector is regulated and supervised by the Reserve Bank of India (RBI) and includes institutions such as:

• RBI itself, which plays a central role in controlling liquidity and monetary policy.
• Commercial banks including both nationalized and private banks.
• Co-operative banks, which serve regional and community needs.
• Other financial institutions like Non-Banking Financial Companies (NBFCs), mutual funds, and insurance companies.

The organised sector operates under structured rules and licensing, providing short-term funds through instruments like Treasury bills, commercial papers, and certificates of deposit.

Co-operative Sector

This includes co-operative banks that primarily cater to rural and semi-urban areas, supporting agriculture, small industries, and trade by providing short-term credit facilities in a regulated yet community-focused manner.

Unorganised Sector

The unorganised sector consists of indigenous bankers, moneylenders, and other informal sources of finance. It is largely unregulated by the RBI and operates on traditional trust-based mechanisms. Despite lacking formal regulation, it plays a significant role in providing credit for short durations, especially in rural and semi-urban areas where formal institutions have limited reach.

Money market instruments in India are short-term financial tools used for borrowing and lending money with maturity periods typically less than one year. Key types include:

Call Money

This is short-term borrowing or lending for a very short period, usually overnight. It is primarily used by banks to meet their reserve requirements and manage liquidity fluctuations. The interest rate on call money is known as the call rate.

Notice Money

Notice money loans have a maturity period ranging from 2 to 14 days. Borrowers need to give prior notice to lenders before repayment, typically used for short-term funding needs slightly longer than call money.

Term Money

Term money refers to loans and deposits with a fixed tenure longer than 14 days but less than one year. It is used by banks and financial institutions to meet medium-term liquidity needs. The interest rate on term money is usually higher than call money, reflecting the longer duration.

Overview of Money Market Instruments

• Repurchase Agreements (Repos): A repo is a short-term borrowing arrangement where one party sells government securities to another with a promise to repurchase them later at a slightly higher price. It functions like a secured loan, with the difference in price representing the interest (repo rate). In India, repos are widely used by banks and the Reserve Bank of India (RBI) to manage liquidity and finance. They are critical for short-term liquidity adjustments in the financial system.
• Treasury Bills (T-Bills): These are short-term government securities with maturities ranging from 91 days to one year. They are issued at a discount and redeemed at face value at maturity. T-Bills are considered a safe investment and used by the government to manage short-term borrowing requirements.
• Commercial Bills: These are short-term negotiable instruments used in trade to finance the sale of goods. A commercial bill is drawn by the seller on the buyer and accepted by the latter, promising payment on the due date. They facilitate working capital financing for businesses.
• Commercial Papers (CPs): These are unsecured, short-term promissory notes issued by companies to raise funds for working capital needs or temporary liquidity shortages. CPs generally have maturities ranging from 7 days to one year and are issued at a discount. They are a popular instrument for corporate borrowing in the money market.

Overview of Other Instruments

• Certificate of Deposits (CDs): CDs are short-term negotiable money market instruments issued by commercial banks to raise funds from the public. They have a fixed maturity period ranging from 7 days to 1 year and offer higher interest rates compared to regular bank deposits. CDs are secure, liquid, and transferable in the secondary market, making them attractive for investors looking for short-term, low-risk investment options.
• Money Market Mutual Funds (MMMFs): These are mutual fund schemes that invest primarily in money market instruments like T-bills, commercial papers, and certificates of deposit. MMMFs provide investors with a low-risk avenue for parking short-term surplus funds while offering liquidity and better returns than traditional savings accounts. They are managed by professional fund managers and regulated by securities market authorities.
• Discount and Finance House of India (DFHI): DFHI is a specialized financial institution established to develop and strengthen the money market in India. It acts as a primary dealers' institution and provides liquidity to the money market by dealing in government securities and money market instruments. DFHI facilitates the smooth functioning of the money market by offering services like repo and reverse repo transactions, discounting bills, and serving as an intermediary in government securities transactions.

The Indian Capital Market is a segment of the financial market that facilitates the mobilization of medium and long-term funds (typically longer than one year) for economic development. It connects investors with surplus funds to businesses and governments needing capital for expansion and growth.

Capital Market Instruments

The instruments typically traded in the capital market include:

• Shares (Equity)
• Debentures and Bonds (Debt)
• Preference Shares
• Derivatives (futures and options)
• Mutual Fund Units

Primary Market (New Issue Market)

The primary market, also called the New Issue Market, is where new securities are issued and sold for the first time. It is the platform for companies and governments to raise fresh capital by issuing new shares, bonds, or debentures. Key activities include Initial Public Offerings (IPOs), rights issues, and preferential allotments.

- Listing of Securities: After issuance, securities are listed on stock exchanges to provide liquidity and enable trading in the secondary market. Companies must meet listing requirements and obligations for transparency and disclosure.

The Secondary Market is where previously issued securities such as shares and bonds are traded among investors. It provides liquidity and price discovery, enabling investors to buy and sell securities after the initial issuance in the primary market.

Stock Exchanges and Their Functioning

In India, the major stock exchanges are the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). These are regulated platforms that facilitate transparent and efficient trading of securities through computerized order matching systems. Stock exchanges perform key functions such as:

• Providing a marketplace for trading securities
• Ensuring liquidity and marketability of securities
• Facilitating price discovery through demand and supply mechanisms
• Regulating trading activities to prevent market manipulation
• Ensuring investor protection through transparency and disclosures

Indian Clearing Corporation Ltd. (ICCL)

ICCL acts as the clearing and settlement agency for trades executed on NSE. It acts as an intermediary between buyers and sellers to ensure the smooth and timely settlement of securities transactions. ICCL mitigates counter-party risk by guaranteeing the settlement of trades and handles clearing, settlement, risk management, and collateral management services for the exchange.

Role of Securities and Exchange Board of India (SEBI)

SEBI is the regulatory body overseeing capital markets in India. Its primary roles include:

• Regulating stock exchanges and market participants
• Protecting investor interests by enforcing transparent practices and disclosure norms
• Preventing fraudulent and unfair trade practices such as insider trading and price manipulation
• Promoting orderly development of securities markets and investor education

Commodity markets are venues where raw materials or primary products like metals, agricultural products, oil, and natural resources are traded. These markets help producers and consumers of commodities hedge price risks, provide price discovery, and contribute to global economic activity by facilitating trade in physical goods and commodity derivatives.

Euromarkets refer to international financial markets where currencies and securities are traded outside the jurisdiction of the countries that issue these currencies.

• Eurocurrency Market: This is a market for currencies deposited in banks outside their home country. For example, US dollars deposited in European banks constitute Eurodollars. These markets provide a wide range of short-term and long-term financing options for international borrowers and investors without the regulation of the domestic markets.
• Eurobond Market: Eurobonds are international bonds issued in a currency different from the home country of the market where they are issued. They offer companies and governments the advantage of tapping into international capital markets without being subject to the regulations of any single country’s market.