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Course Objective
To make students aware of variousaspects of a financial system likebanking, insurance, mutual funds, capital
markets, portfolio management etc. To provide students with an
understanding of various trading andsettlement regulations in both domesticas well as international markets
To enable students to apply theoreticalknowledge into the real world
To enable students to apply various skillslike information technology, accountingetc. to develop analytical skills in financial
services To develop an ability to access and
assimilate information and updateknowledge in financial markets.
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Course outline
Introduction to the Financial system
Financial services provided by Banks
Trading and settlement in stock markets
Mutual fund schemes and comparison of
mutual funds
Merchant banking, book building, initial
public offer (IPO)
Insurance plans, Unit linked Insurance
plans (ULIP), schemes in insurance
International financial markets
Issue of ADR and GDR
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Financial System Definition
A system is a set of interrelated parts working together to
achieve some purpose
A financial system is a set of complex or closely connected
or inter mixed institutions, agents, practices, markets,
claims and so on in any economy. It can therefore be defined as
that part of the economy which includes all the
institutions involved in moving savings from savers
(households and firms) to borrowers, and in
transferring, sharing, and insuring risks;
it includes financial institutions / intermediaries like
banks, insurance organizations, unit trusts/ mutualfunds markets, bond markets, and the stock market
which collect capital from savers/investors and
distribute them to the entrepreneurs / productive
enterprises
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Constituents of a financial
System
Components of financial systems
Formal systems
Financial institutions
Financial markets Financial instruments
Informal systems
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Basic functions of financial
systems
Financial systems are of crucial significance to capitalformation which in turn is indispensable for economicgrowth
Process of capital formation involves three distinct
although interrelated activities Savings ability by which claims to resources are set
aside and become available for other purposes
Finance The activity by which resources are assembledfrom domestic savings or obtained from abroad, orspecially created usually as bank deposits or notes andthen placed in the hands of investors
Investments The activity by which resources arecommitted to production
There are three types of economic units
Saving surplus units
Savings deficit units
Neutral units
If capital formation has to take place savings must be
transferred from saving surplus units to savings deficitunits.
Financial systems act as a link between savers andinvestors and thereby aid capital in capital formation
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Role of financial intermediaries
Indirect finance refers to the flow of savings from thesavers to entrepreneurs through intermediary financialinstitutions like mutual funds, insurance companies etc.
Financial intermediaries come in between the ultimateborrowers and ultimate lenders in the savings
investment process Financial intermediaries play a vital role in economic
development via the capital formation process. Theirrelevance to the flow of savings is derived from what iscalled transmutation effect that is the ability to convertcontracts with a given set of features into contracts withdifferent features.
Financial intermediaries provide services formobilization of savings as well as their channelization
Services provided under mobilization of savings are Convenience
Divisibility
maturity
Lower risk
Expert management
Economics of scale
Financial intermediaries play a crucial role in theeconomic development by directing savings in tune withdevelopmental priorities
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Financial intermediaries
Important intermediaries operating in thefinancial markets include; investment bankers,
underwriters, stock exchanges,
registrars, depositories, custodians,
portfolio managers,
mutual funds,
financial advertisers, financial consultants,
primary dealers, satellite dealers,
Though the markets are different, theremay be a few intermediaries offering theirservices in more than one market e.g.
underwriter. However, the servicesoffered by them vary from one market toanother.
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FINANCIAL INTERMEDIATION
Intermediary Market RoleStock Exchange Capital Market Secondary Market to
securitiesInvestment Bankers Capital Market, Credit Market Corporate advisory services,
Issue of securitiesUnderwriters Capital Market, Money
Market Subscribe to unsubscribedportion of securitiesRegistrars, Depositories,
Custodians Capital MarketIssue securities to the
investors on behalf of the
company and handle share
transfer activityPrimary Dealers SatelliteDealers Money Market Market making ingovernment securitiesForex Dealers Forex Market Ensure exchange ink
currencies
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Functions of Financial
Institutions and Markets
Assemble funds
Allocate capital
Interest rates and prices of financial instruments
Quantities to borrowers and lenders
Absorb risk Analyse and disseminate expensive and financial
information
Risk of debt and equity issues and issuers
Valuation of debt and equity
Valuation of derivatives
Volumes of debts and equities Ownership of debts and equities
Monitor primary issuer performance
Distribute Primary Securities
Investigate issuers of debts and equities as to their futureperformance
Underwrite securities i.e. guarantee a price for the
security issue and accept the risk of security issue Wholesale distribution of security to underwriters and
dealers
Retail distribution of securities through a sale to the openmarket via brokers and dealers
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Functions of Financial Institutions
and Markets (cont.)
Provide for secondary market for primary,
secondary and derivative securities. The
secondary market is the market for
outstanding securities where most tradingtakes place
Intermediate between the preferences of
primary security issuers and ultimate
savers Other functions
Maturity intermediation
Reducing risk via diversification
Reducing the cost of contracting and
information processing Providing a payment mechanism
Asset / Liability management
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Relationship between financial
system and economic growth
Existence of financial system facilitates economic
activity and growth.
Markets, institutions and instruments are the
prime movers of economic growth. Financial system diverts savings to productive
uses, it helps to increase output of the economy
Helps accelerate the volume and rate of savings
by providing diversified range of financial
instruments and services
Makes innovation least costly and most profitable
thereby enabling a faster economic growth
Financial system is useful in evaluating assets,
increasing liquidity and producing and spreading
information
Economic growth in turn develops financial
system as they increase trading activities and
develop new risk management products to keep
pace with growth
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Relationship between financial
system and economic growth (cont.)
Financial markets represent deep end of thefinancial system; deeper the system, greater thestability and resilience. A well developed moneyand govt. securities market helps the Central
Bank to conduct monetary policy effectively withthe help of market based instruments
The financial system plays an important role indisciplining and guiding management ofcompanies leading to sound corporategovernance
The domestic financial system when linked tointernational financial system, increases capitalflow with the help of financial markets. This linkreduces risk through portfolio diversification andhelps in accelerating economic growth
There is a symbiotic relationship between
financial system and economic growth. Asophisticated and sound financial accelerateseconomic growth and the financial system in turndevelops more with economic growth
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Relationship between financial
system and economic growth
Market frictions Information costs
Transactions cost
Financial markets and intermediaries
Financial market Functions (Services)
Liquidity
Risk diversification
Rapid information
Corporate control
Savings mobilisation
Channels to growth
Capital accumulation Technological innovations
Economic Growth
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Financial institutions
Banking institutions
Scheduled Commercial Banks
Public Sector Banks
Private Sector Banks
Foreign Banks
Regional rural Banks
Scheduled Co-operative
Non banking institutions
Non Banking Financial Companies
Development Financial Institutions
All India Financial Institutions ( IDBI, IFCI, IIBI,
NABARD,SIDBI, NHB etc)
State Level institutions ( SFCs, SIDCs)
Other Institutions (DICGC,ECGC)
Mutual Funds
Public
Private
Insurance and housing finance companies
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Financial Markets
A Financial Market can be defined as the market in whichfinancial assets are created or transferred. As against a realtransaction that involves exchange of money for real goods orservices, a financial transaction involves creation or transfer ofa financial asset. Financial Assets or Financial Instrumentsrepresents a claim to the payment of a sum of money
sometime in the future and /or periodic payment in the form ofinterest or dividend.
Money Market- The money market ifs a wholesale debtmarket for low-risk, highly-liquid, short-term instrument. Fundsare available in this market for periods ranging from a singleday up to a year. This market is dominated mostly bygovernment, banks and financial institutions.
Capital Market - The capital market is designed to finance
the long-term investments. The transactions taking place inthis market will be for periods over a year.
Forex Market - The Forex market deals with the multicurrencyrequirements, which are met by the exchange ofcurrencies. Depending on the exchange rate that isapplicable, the transfer of funds takes place in thismarket. This is one of the most developed and integratedmarket across the globe.
Credit Market- Credit market is a place where banks, FIs andNBFCs purvey short, medium and long-term loans tocorporate and individuals.
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Financial Markets (contd.)
Capital Market Equity
Primary Public issues
Private placement Domestic International
Secondary NSE, BSE, OTCI, ISE, Regional Stockexchanges
Derivatives Exchange traded - Futures and options
Index,
Stock
Debt Private Corporate
PSU Bond
Government securities market Primary, Secondary
Money Market Treasury Bills,
Call Money Market
Commercial bills
Commercial Papers
Certificates of deposits Term money
Primary Segment
Secondary Segment
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Money Market Instruments
1. Call /Notice-Money Market
Call/Notice money is the money borrowed or lent ondemand for a very short period. When money is borrowedor lent for a day, it is known as Call (Overnight) Money.Intervening holidays and/or Sunday are excluded for this
purpose. Thus money, borrowed on a day and repaid onthe next working day, (irrespective of the number ofintervening holidays) is "Call Money". When money isborrowed or lent for more than a day and up to 14 days, itis "Notice Money". No collateral security is required tocover these transactions.
2. Inter-Bank Term Money
Inter-bank market for deposits of maturity beyond 14 days
is referred to as the term money market. The entryrestrictions are the same as those for Call/Notice Moneyexcept that, as per existing regulations, the specifiedentities are not allowed to lend beyond 14 days.
3. Treasury Bills.
Treasury Bills are short term (up to one year) borrowinginstruments of the union government. It is an IOU of theGovernment. It is a promise by the Government to pay a
stated sum after expiry of the stated period from the dateof issue (14/91/182/364 days i.e. less than one year). Theyare issued at a discount to the face value, and on maturitythe face value is paid to the holder. The rate of discountand the corresponding issue price are determined at eachauction.
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Money Market Instruments
(contd.)
4. Certificate of Deposits
Certificates of Deposit (CDs) is a negotiablemoney market instrument issued indematerialised form or as a Usance Promissory
Note, for funds deposited at a bank or othereligible financial institution for a specified timeperiod. CDs can be issued by
scheduled commercial banks excluding RegionalRural Banks (RRBs) and Local Area Banks (LABs);and
select all-India Financial Institutions that have beenpermitted by RBI to raise short-term resourceswithin the umbrella limit fixed by RBI. Banks havethe freedom to issue CDs depending on theirrequirements. An FI may issue CDs within theoverall umbrella limit fixed by RBI, i.e., issue of CDtogether with other instruments viz., term money,
term deposits, commercial papers andintercorporate deposits should not exceed 100 percent of its net owned funds, as per the latestaudited balance sheet.
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Money Market Instruments
(contd.)
5. Commercial Paper
CP is a note in evidence of the debt obligation ofthe issuer. On issuing commercial paper the debtobligation is transformed into an instrument. CP is
thus an unsecured promissory note privatelyplaced with investors at a discount rate to facevalue determined by market forces. CP is freelynegotiable by endorsement and delivery. Acompany shall be eligible to issue CP provided
the tangible net worth of the company, as per the
latest audited balance sheet, is not less than Rs. 4crore;
the working capital (fund-based) limit of thecompany from the banking system is not less thanRs.4 crore and
the borrowal account of the company is classifiedas a Standard Asset by the financing bank/s.
The minimum maturity period of CP is 7 days. Theminimum credit rating shall be P-2 of CRISIL orsuch equivalent rating by other agencies.
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Money Market Instruments
(contd.)
Capital Market Instruments
The capital market generally consists ofthe following long term period i.e., more
than one year period, financialinstruments; In the equity segment Equityshares, preference shares, convertiblepreference shares, non-convertiblepreference shares etc and in the debt
segment debentures, zero coupon bonds,deep discount bonds etc.
Hybrid Instruments
Hybrid instruments have both thefeatures of equity and debenture. This
kind of instruments is called as hybridinstruments. Examples are convertibledebentures, warrants etc.
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Financial Instruments/
Assets/Securities
Equity / Ordinary shares
Debentures
Preference shares
Innovative instruments Issued by companies
Participating debentures
Convertible debentures with options
Third party convertible debentures
Convertible debentures redeemable at premium
Debt equity swaps
Secured premium notes with detachable warrants
Zero coupon convertible notes
Non convertible debentures with detachable equity
warrants
Zero interest fully convertible debentures
Fully convertible debentures with interest
Warrants
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Innovative instruments contd.
Issued by Financial institutions
Floating rate bonds
Zero coupon bonds / Deep discount bonds
Easy exit bond with a floating interest rate
Easy exit bonds with floating interest rates
Regular income bonds
Retirement bonds
Set up liquid bonds
Growth bonds
Index bonds
Capital gains bonds
Encash bonds
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Opportunities of the 21st Century
New technology Proliferation of new services
Development of new market areas
Reduction of operational costs
Globalization
Growth of international financial institutions Increased competition for customers and markets
Specialized niches for boutique firms
Continuing Consumer Concerns Bigger is not necessarily better (service)
Security of personal financial information Identity theft
Damaging credit reports Bad management of large financial institutions can lead
to: Loss of funds
Loss of credit
Widespread negative economic impact
Financial Assets versus Real Assets A financial asset is a contract that offers a promise of payment (or
the option to receive payment) in the future from the party thatissued the contract. Examples include securities, loans, etc.
Real assets are those assets expected to provide benefits basedon their fundamental qualities. Examples include inventory, realestate, etc.
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Differences between Financial
Institutions and Non-financial Firms
Depository
Institutions
Non-financial
Firms
Assets
Most assets are
financial assets
Most assets are
real assets
Financing
of the firm
High financial
leverage is normal
and advantageous
Moderate financial
leverage is normal;
high is dangerous
Asset
LiquidityVery High More moderate
Liability
LiquidityQuite High More moderate
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Types of Financial Institutions
Depository Institutions1
Commercial banks Thrift institutions
Savings & loan
associations
Savings banks
Credit unions
Non-Depository
Institutions Finance companies
Contractual
intermediaries Pension funds
Insurance
companies
Investment
companies
Mutual fundmanagement
companies
Real estate
investment trusts
(REITs)
Securities firms
Securities brokers Investment banks
Government-
sponsored
enterprises
1Depository institutions take
deposits and make loans.
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Depository Institutions
Depository Institutions
are financial institutions that take deposits andmake loans
control the largest proportion of financial assets.
Depositors are protected from loss of funds bydeposit insurance via quasi-federal agencies
Builds depositors confidence in financial system
Provides another level of regulatory oversight
Commercial Banks Banks hold primarily securities and loans as
assets
Banks have been the primary source of short-termand intermediate-term loans
Their loan portfolio is the most diversified andcredit risk is their largest risk
Banks major source of funds are customerdeposits
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Depository Institutions (contd)
Thrift Institutions
Savings and loan associations (S&Ls) andsavings banks traditionally rely on savingsdeposits as sources of funds.
S&Ls have expanded beyond their traditionalrole as mortgage suppliers.
Savings banks resemble S&Ls, but they havemore diversified asset bases.
Credit Unions (CUs)
CUs are not-for-profit organizations
CUs are subject to a common bondrequirement and cannot make commercialloans
CUs have aggressively stretched commonbond boundaries, becoming more like banksby offering credit cards and other investmentservices
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Depository Institutions (contd)
Finance Companies
Finance companies provide
Loans to businesses and consumers who can notqualify for bank loans
Provide liquidity to businesses by financing their mostliquid assets (accounts receivable)
Loans at higher interest rates than banks
Major sources of funds include
Loans from commercial banks
Selling commercial paper and bonds
Contractual Intermediaries Operate under formal agreements with
policyholders or pensioners who entrust their fundsto these firms.
Provide financial vehicles for
Risk management
Retirement savings
Defined contribution retirement plans have largelyreplaced defined benefit plans
Assets are primarily long term investments
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Depository Institutions (contd)
Investment Companies
Investment companies include mutual funds,money market funds, and REITs
Provides professional management of diversified
portfolios to individual investors Economies of scale offer the benefits of:
professional management
reduced costs
reduced risk exposure within large, diversifiedportfolios.
Securities Firms Provide retail brokerage services including buying
and selling stocks, bonds, and other financialassets for customers
Make a market in financial securities by buying andselling the same securities themselves
Sell investment banking services including thecreation and issuance of new securities (individualpublic offerings or IPOs)
Provide financial consulting services
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Industry Differences
Major differences exist between financialinstitutions in their
Asset and liability distributions
Services offered to the public
Riskiness of invested funds
Legal structure
There are significant differences in the lawsregulating their operations and governmentagencies acting as regulators.
Economic Functions of financial Institutions Intermediation (transfer of funds, securities) Reduced transactions and information costs
Liquidity For markets
For individual parties (companies or individuals)
Information and contacts
Transfer of risk Creation of financial instruments
Creation of money
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Primary versus Secondary
Securities and Markets
For securities
Primary (direct) securities are claims against
individuals, governments, and nonfinancial
firms. Secondary (indirect) securities are financial
liabilities of financial institutions.
For Markets
Primary markets: Securities are initially offered
(IPO) and issuing party receives the funds Secondary markets: Outstanding securities
are traded from one holder to another and
issuing party receives no funds.
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Primary and Secondary
Securities
Primary Securities Secondary Securities
Commercial Loans Savings Deposits
Mortgage Loans Transaction Deposits
Consumer Loans Certificates of Deposit
Government Bonds Insurance Policyholders
Reserves
Corporate Bonds Mutual Fund Shares
Corporate Common
Stock
Pension Fund Reserves
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Financial Intermediation Benefits
Reduction of transactions and information costs
Information and Search Costs
Portfolio Selection and Denomination Costs
Monitoring Costs
Risk Management Costs Maturity Intermediation and Liquidity
Exchange of securities with different characteristics
Transfer of risk
Search Costs
Financial institutions provide ways to identify entities with
excess funds and those needing funds. This identification by financial institutions eliminates the
need for individual lenders and borrowers to find oneanother.
Portfolio Selection Costs
Investors may wish to invest in financial assets in differentdollar amounts, with different maturities, or with different
risk levels from the financial liabilities borrowers wish toissue.
Financial institutions issue secondary securities tolenders, and then repackage funds in forms attractive toborrowers.
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Financial Intermediation Benefits
(contd.)
Monitoring Costs Asymmetric information exists when managers have one
set of information and investors have a different set ofinformation.
Managers are generally better informed about their firmsprospects, so they generally have a better set ofinformation.
Information asymmetry gives rise to monitoring costs -ongoing expenses incurred by investors to gatherinformation so they can intervene if borrowers financialsituations change.
Risk Management Costs Investors can avoid the risk of a single party defaulting on
its obligations by holding shares in a mutual fund
Insurance companies can pool premiums and provide riskmanagement at much lower cost Banks provide letters of credit that guarantee payment by
other parties, reducing risk Investment and commercial banks provide instruments
that can protect against interest rate and foreignexchange risk
Maturity Intermediation and Liquidity
Banks accept small amounts from small investors asdeposits and transform them into longer-term loans
Banks borrow short-term (from depositors) and lendlonger-term
Checks, credit cards, electronic payments, and bank wirescan be used to make payments in lieu of cash
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The Changing Role of Financial
Institutions in the Technological Age
New risks with technology Societal Concerns
Serving the community Services for the unbanked Community Reinvestment Act
Accounting & Ethical Concerns Enron Arthur Anderson Investment bankers providing false information Mutual fund management practices Corporate Governance Scandals
Financial Institution Management Who sets objectives?
Stockholders versus stakeholders
Normative versus positive theory approach
Agency theory
Customer needs
Regulations providing limits
What is the goal of the firm?
Economic Value Added (EVA) A goal for risk-profitability management
Measures profitability after Long term debtholders earn their return
Stockholders and other investors earn their return
Can be used for individual capital allocation decisions