Overview of the Financial System

No Comments

Print Friendly, PDF & Email

 

ABOUT FINANCIAL SYSTEMS

The financial system is a complex but well-integrated system that mobilizes and allocates scarce resources of a country.

Background

 

 

 

 

 

 

 

 

 

The mobilization and allocation of scarce resources requires a regular supply of funds that is intermediated through the financial system across a set of sub-systems – financial institutions, financial services and financial markets. Accordingly, this system is governed by regulation that ensures efficiency across the sub-systems in the financial sector.

REGULATION – ROLE & FUNCTION

Regulation in the financial system in India has originated as a means to control existing or possible inefficiencies or market failures[1] within the system. The government has set regulations by appointing regulatory bodies or agencies who are responsible for defining the objectives of the regulatory framework, identifying specific activities required to be performed and determining the medium of implementing the regulatory activities [2]. The regulatory bodies are generally independent and accountable for all activities in the financial system and are considered effective with regards to the financial system in India.

Why Regulation

 

 

 

 

 

 

 

 

 

 

 

 

The broad objective of regulatory bodies is to enable efficient functioning of the financial sector. This efficiency can be facilitated by setting a regulatory framework for [3]:

  1. Managing the functioning of the overall economy.
  2. Avoiding contagion or crisis and information asymmetry
  3. Protecting individual interests
  4. Ensuring adherence to the norms, rules, guidelines and policy

The objectives of the regulatory bodies can be met by the following [4]:

  1. Implementing legislative acts – Legislative acts are laws passed by legislature that confers relevant regulatory bodies to implement or enforce the law on relevant stakeholders [5]. For example, the Banking Regulation act, 1949 that defines the activities and adherence to norms prescribed by the RBI for banks in India
  2. Establishing financial intermediaries – Under the legislative acts, governments establish financial intermediaries and confer relevant responsibilities. The financial intermediaries are accordingly responsible for mobilizing savings to investments, creating easy access to short-term and long-term funds and enabling risk diversification
  3. Enhancing competition – Healthy competition has been initiated by regulatory bodies that has allowed private sector participation in the financial system in addition to increased autonomy to public sector institutions. For example, the presence of private banks and foreign banks in banking sector has encouraged other public sector banks to offer innovative services like ATMs, Internet banking, etc. Similarly, public sector banks like State Bank of India and its associate banks operate without any government intervention.
  4. Dispute resolute mechanism- There are dispute settlement mechanisms set by regulatory bodies to address grievances of individuals, companies or governments. For example, “The banking Ombudsman Scheme 2006” allows an individual to report a grievance related to loan, credit card, etc matters to the RBI and are accordingly resolved [6].
  5. Market deepening – Major objective of reforms programme is to integrate various segments of the financial system to reduce arbitrage opportunities. Arbitrage means buying/selling commodities, bonds or stocks to gain profit in case of price discrepancies. For example, if the price of an iPod on Flipkart.com is Rs 5000 and a local store offers the same Ipod for Rs 6000, then you can buy all iPods from Flipkart and sell them at the local store for Rs 6000 making a profit of Rs 1000 on each iPod. The process of buying and selling iPods at different prices is an arbitrage where you take advantage of inequality in prices. If the market had increased depth, the prices of an iPod would have been relatively the same thus promoting healthy competition. Market depth means that individuals or companies can have equal access to different financial services across capital and money markets in large volumes without leading to fluctuations or speculation in market prices of commodities, stock, bond etc.
DEFINITION OF FINANCIAL SERVICES & ITS MEANING
“the collection of organizations which intermediate and facilitate financial transaction of individuals and institutional investors resulting from their resources allocation activities through time” – Financial Markets, Institutions and Financial Services by Clifford Gomez

The definition can be interpreted by identifying significant elements of

Why Financial Services?

financial services as shown below:

  1. Financial services are provided by financial intermediaries (banking/non-banking)
  2. Financial intermediaries offer these services through financial instruments such as deposits, credit cards, loans, equities/shares, debentures, etc
  3. These instruments are offered to their customers or investors who are willing to partake a part of their incomes with the purpose of gaining more than average returns at a particular time period.
  4. Customers or investors include – individuals or retail customers, Small and Medium Enterprises (SMEs), large corporations (Indian and Multi-National Companies) and the government (state or central)
  5. The objectives of investment in financial instruments for every investor can be different as follows:
  • Personal – Investments in housing, car financing, credit cards, education plan, life and property insurance, etc
  • Debt financing – Companies (small, medium or large) generally require working capital or funds for day-to-day operational activities
  • Future expansions – Companies (small, medium or large) invest/reinvest for gaining more assets or control over other businesses. Companies also raise funds from investors in the form of equities or debts and reinvest for future expansions
  • Trade – Companies (small, medium or large) involved in exports/imports of goods and services require insurance, loans, and various other financial services for effectively trade
  1. Financial services thus aim at providing liquidity or ease in accessibility of funds to investors for avoiding exposures from risks and uncertainties along with gaining higher returns

ROLE OF FINANCIAL INTERMEDIARIES

Financial intermediaries established under relevant legislative acts consist of banking and non-banking institutions [7]. Banking institutions are considered to be creators and purveyors of credit. These institutions mobilize small savings accounts of individuals to large loans for other individuals, companies and governments in accordance to certain limits and norms prescribed by the regulators. Conversely, non-banking institutions like LIC, UTI, etc are considered to be purveyors of credit. This implies that these institutions demand a small payment from customers for a regular time period that accumulates as debt and is repaid to the customers at a premium at a later date (after maturity). Financial intermediaries mobilize the funds from investors to companies with the objective of allocating relevant resources for facilitate efficient functioning of the economy. Accordingly, financial intermediaries are also regulated by regulatory bodies that prescribe adherence to norms, limits and policies. Based on relevant prescriptions, these institutions offer financial services comprising financial instruments that facilitate funds between borrowers (companies) and investors.



[1] Market failure is an economic concept related to inefficiencies in allocation of goods & services in a market. The concept implies that only few people gain benefits making a large number of people worse-off thus leading to inefficiencies

[2]  http://rbidocs.rbi.org.in/rdocs/Publications/PDFs/40092.pdf

[3] Mathur., K. B. L., Regulation of India’s Financial Sector: The State’s Role, Economic and Political Weekly, Vol. 39, No. 12, Money, Banking and Finance (Mar 20-26, 2004)

[4] Mathur., K. B. L., Market Orientation of Financial Sector: State as Facilitator, Economic and Political Weekly, Vol. 40, No. 12, Money, Banking and Finance (Mar 19-25, 2005)

[5]Stakeholders are individuals or group of individuals who affect or are affected by an institution’s action

[6] http://www.rbi.org.in/Scripts/bs_viewcontent.aspx?Id=159

[7] The Indian Financial System: Markets, Institutions and Services, 2nd and 3rd Edition, by Bharati V. Pathak