The document discusses the core functions and components of a financial system. It explains that a financial system facilitates the allocation of resources across time and space in an uncertain environment. It also discusses key innovations like money, warehouse banks, checks, and fractional-reserve banking that helped financial systems evolve. Additionally, it covers financial institutions, markets, instruments, and services. It analyzes problems and risks in lending and trade, and how financial intermediaries help address these issues through indirect lending.

1. FINANCIAL SYSTEM
Prof. N K Jain
Jamia Hamdard

2. FINANCIAL SYSTEM
• The core function of the financial system is to
facilitate the allocation and deployment of
economic resources, both across the time and
space, in an uncertain environment.
• The Financial system is changing due to
innovation. Innovation may be by creating new
products which serve an existing need or by
using existing technology to serve new needs.

3. FINANCIAL SYSTEM
FINANCIAL
SYSTEM
Financial Financial Financial Financial
Institutions Markets Services Instruments

4. Six Core Functions of Financial
System
• Provides a payment system for the exchange of goods
and services.
• Provides a mechanism for the pooling of funds.
• Provides a way to transfer economic resources through
time and across geographic regions and industries.
• Provides a way to manage uncertainty and control risk.
• Provides price information that helps coordinate
decentralised decision-making in various sectors of the
economy.
• Provides a way to deal with the asymmetric-information
problems when one party to a financial transaction has
information that the other party does not.

5. FINANCIAL INSTITUTIONS
FINANCIAL
INSTITUTIONS
Regulatory Intermediaries Non-intermediaries Others
• Financial institutions change their structure
over time and across geographical
subdivisions to perform the functions of
financial system more efficiently.

6. Classification of Financial
Institutions
Transparent Translucent Opaque
Govt. Bond Unit Trusts Finance
Market Companies
Stock Market Mutual Funds Insurance
Companies
Futures and Pension Funds Commercial
Options Markets Banks

7. Financial Markets
Financial Markets
Capital Markets Money Markets
Organised Unorganised
Primary Secondary

8. Financial Markets
• The essential difference between money market
and capital markets is based on the maturity of
claims.
• Money market deals in short-term instruments
i.e. maturity of less than one year e.g. Treasury
Bill Market, Call Money Market and Commercial
Bill Market.
• Capital market deals in longer maturity
instruments e.g. Stock Markets and Government
Bonds Markets

9. Capital Markets
• The capital markets comprises cash-flow cycle in which
household savings are channeled into capital investment
by firms and then returned to households via dividends,
security repurchases and interest payments for
consumption and recycling as new savings.
• Financial markets tend to be efficient institutional
alternatives to intermediaries when the products have
standardised terms, can serve a large number of
customers and are easy to be understood by large
number of customers.
• Intermediaries are better suited for low volume products.

10. Financial Services
Financial Services
Banks Mutual Funds Insurance
Commercial Investment
Property Life Non-acturial

11. Financial Instruments
Financial Instruments
Primary Secondary
Short Term Medium Term Long Term

12. Trade
• The Financial system makes it easy to trade.
• People trade because they differ in what they have and
in what they want. The basis of trade is diversity. It
makes room for specialisation.
• Trading makes ample economic sense.
• Lending is also a form of trade. One gives up purchasing
power now in exchange for purchasing power in the
future.
• Some people have purchasing power now but want
purchasing power later.
• Others expect to have purchasing power later but want
purchasing power now.

13. SAVINGS AND WEALTH
• Life-Cycle Pattern of saving: It refers to pattern of
borrowing and repayment, saving and dis-saving, over a
lifetime.
• Turning Wealth into Income: owners of wealth do not
wish to exercise the purchasing power immediately
• Precautionary Reserve: assets held as protection
against fluctuations in income or spending.
• Savers and holders of wealth are potential lenders.
• Potential borrowers are businesses and households.
They need purchasing power now to invest for a long
period.

14. SAVINGS AND WEALTH
• Business Investment: All businesses make substantial
outlays before they start any earnings. Investment in
fixed capital and working capital are both productive.
They add to future income stream.
• Thus investment involve a timing problem. Without the
purchasing power now, future rewards cannot be
obtained.
• Household Investment: Investment in higher education,
purchase of a house or a car either increase future cash
flows or provide a stream of consumption services over
time.
• Households face the same timing problem in making
investment as do businesses.

15. GAINS IN TRADING OF
BORROWING AND LENDING
• Savers and wealth-holders wish to trade current
purchasing power in the future.
• Businesses and households need purchasing
power now to finance investments.
• Borrowers gain because they expect to earn
much more than the interest they may be
required to pay on borrowings.
• Lenders gain because they get a better return
than they could achieve otherwise.

16. Trade in Risk
• Businesses and households face a variety of risks. Trade can
reduce the economic burden of these risks substantially.
• Two principal form of risk mitigation
– insurance and forward transaction
INSURANCE
• Insurance is particularly useful in case of accidents, illness and
natural disasters.
• Reciprocal Insurance: An agreement whereby those facing a
particular risk agree to share their losses. e.g. mutual aid and gift
exchange
• External Insurance: An agreement whereby those who do not face
a particular risk agree to share the losses of those who do.
• Insurance softens the blow of the loss. The benefit is more than the
cost of the insurance.

17. Trade in Risk
• FORWARD TRANSACTIONS
• This may be broadly referred to price risk – The
risk of an adverse change in market prices.
• Price risk can be mitigated through forward
transaction. It is a transaction in which two
parties agree in advance on the terms of trade to
be carried out at a specified future time.
• The people who are willing to take other side of
the trade may be either a hedger or speculator.
• Not all trade in risk is driven by the desire to
reduce risk e.g. “Gambling and Lotteries”.

18. Difficulties Encountered in
Lending
• A lender gives up purchasing power today in exchange for a
promise of payment tomorrow. The borrower may not keep his
promise.
• Lending is made after evaluating the potential reward against
chance of loss due to default.
• A lender seeks information about the borrower before committing his
funds:
• It is difficult for an individual to gather, analyse and evaluate the
information for its reliability.
• Even after the screening if one decides to go ahead with lending, the
transaction has to be recorded as an agreement. It may be difficult
and expensive for an individual to do all this.
• Loan covenant safeguards the interest of the lender and restricts
the borrower’s behaviour in various ways.
• Liquidity: Lender wishes that the loan to be as liquid as possible
while a borrower wishes commitment of funds over a long period.

19. Summary of the Problems of
Lending
• The cost of acquiring and processing
information
• The cost of negotiating and writing a
contract
• The incentive problems inherent in all
lending arrangements
• The cost of establishing safeguards and of
monitoring borrower compliance (transaction
costs)
• Conflicting interests over liquidity

20. THE PROBLEMS OF TRADE IN
RISK
• INSURANCE
• Moral hazard: leads to tendency among the
insured to take more risk because they have
insurance.
• Adverse selection: is due to tendency of worse
risk to buy insurance and better risks not to.
• FORWARD TRANSACTIONS
• Replacement risk is that a counter party to a
forward transaction will default and have to be
replaced.

21. Innovation in Financial System
• Money: The first innovation in a financial system. It
eliminated the inefficiencies associated with a barter
system. It has facilitated in enlargement of markets over
space and time.
• Warehouse bank: is a bank that keeps depositors’ cash
in storage. They allow depositors to make payments by
transferring title to deposited cash rather than by
transferring the cash itself. There is a one-to-one
correspondence between deposits and cash in the
banks’ vault.
• Check: is an order to a bank to make payment from a
deposit.
• Clearing: is collection process for checks drawn on one
bank are offset against checks drawn on another.

22. Fractional-reserve Banking
• It is a bank that holds reserves of cash equal to only a fraction of its
deposit liabilities.
• A loan creates deposit for a borrower
• This creation of deposits through lending changes the nature of
bank and bank deposit .
• A deposit becomes no more of currency but it becomes a promise
by the bank to pay on demand a certain sum of rupees.
• It is a claim on bank’s assets in general, rather than on any
particular sum of cash in vault.
• This cash in vault becomes a general reserve which is a fraction of
the amount of deposits.
• Commercial bank liabilities usually include several types of non
deposit sources of funds while their loans are broader in range
comprising consumer, commercial and real estate loans

23. Indirect Lending and Financial
Intermediaries
• Direct lending is lending by ultimate
lender to ultimate borrower with no
intermediary.
• Financial intermediary is an institution
that borrows by issuing its own securities
and relends the funds it raises.
• This process is also known as indirect
lending.

24. Indirect Lending and Financial
Intermediaries
• Cost of making loans by a bank is much less
than direct lending due to following reasons:
• INFORMATIONAL ADVANTAGES
• POOLING TO MAKE LARGE LOANS
• GAINS FROM SPECIALISATION
• ADVANTAGE OF A CONTINUING
RELATIONSHIP
• DIVERSIFICATION REDUCES DEFAULT RISK
• LIQUIDITY