This document is the first chapter of a textbook on the Indian financial system by Bharati V. Pathak. It introduces key concepts about financial systems including their components, functions, and types. The chapter objectives are to understand the meaning and design of financial systems, as well as the roles of institutions, markets, instruments and their interlinkages. It describes how financial systems intermediate funds, facilitate resource allocation, and comprise institutions, markets, instruments and services.

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Indian Financial System, 5e
By: Bharati V. Pathak
Indian Financial System
Markets, Institutions and Services

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Indian Financial System, 5e
By: Bharati V. Pathak
Chapter 1
Financial system: An
Introduction

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Indian Financial System, 5e
By: Bharati V. Pathak
Figure 1.1

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Indian Financial System, 5e
By: Bharati V. Pathak
To understand:
1. Meaning of Financial system.
2. Components of the Financial system.
3. Functions of the Financial System.
4. Key elements of the Financial System.
5. Key elements of a well functioning financial system.
6. Bank- based and Market- based financial systems.
7. Nature and role of Financial Institutions and Markets.
8. Link between Money market and Capital market.
9. Link between Primary market and Secondary market
10.Functions and Characteristics of Financial markets.
Chapter Objectives

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Indian Financial System, 5e
By: Bharati V. Pathak
 A set of sub systems of financial institutions,
markets, instruments and services.
 Intermediates with the flow of funds between
savers and borrowers.
 Facilitates transfer and allocation of scarce
resources efficiently and effectively.
Meaning of Financial System

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Indian Financial System, 5e
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•Formal financial system
• Organized, institutional and regulated
•Informal financial system
• Advantages: Low transaction costs,
Minimum default risk and Transparency
of procedures
• Disadvantages: Wide range of interest
rates, Higher rates of interest and
Unregulated
Types of Financial System

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Indian Financial System, 5e
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•Financial Institutions
•Financial Markets
•Financial Instruments
•Financial Services
Components of the Financial
System

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Indian Financial System, 5e
By: Bharati V. Pathak
Types of Financial Institutions
 Banking and Non–Banking
 Banking: creators and purveyors of credit.
 Types: Commercial Banks & Cooperative
Banks
 Non-Banking: purveyors of credit
 Types: Developmental financial institutions;
Mutual Funds; Insurance companies and
NBFCs

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Indian Financial System, 5e
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Functions of Financial Institutions
 Provide three transformation services:
Liability, asset and size transformation
Maturity transformation
Risk transformation

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Indian Financial System, 5e
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Financial Markets
Types: Money Market – A market for short –term debt
instruments.
Capital Market - A market for long -term equity and debt
instruments
Segments: Primary Market – A market for new issues
Secondary Market – A market for tradin outstanding issues

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Indian Financial System, 5e
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Link Between Primary and
Secondary Capital Market
 A buoyant secondary market indispensable
for the presence of a vibrant primary
market
 Secondary market provides a basis for the
determination of prices of new issues
 Depth of the secondary market depends on
the primary market
 Bunching of new issues affects prices in the
secondary market

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Indian Financial System, 5e
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Financial Instruments
Types : Primary & Secondary
Distinct Features : Marketable, Tradeable, Tailor-
made

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Indian Financial System, 5e
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Financial Services
Major categories : Funds Intermediation
Payments Mechanism
Provision of liquidity
Risk Management
Financial Engineering

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Indian Financial System, 5e
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Functions of Financial System
 Mobilise and allocate savings
 Monitor corporate performance
 Provide payment and settlement systems
 Optimum allocation of risk bearing and
reduction
 Disseminate prize related information
 Offer portfolio adjustment facility
 Lower the cost of transactions
 Promote the process of financial deepening and
broadening

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Indian Financial System, 5e
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Key Elements of a Well -
functioning Financial System
 A strong legal and regulatory environment
 Stable money
 Sound public finances and public debt
management
 A central bank
 Sound banking system
 Information system
 Well -functioning securities market

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Indian Financial System, 5e
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Financial System Designs
Types: Bank–based & Market–based

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Indian Financial System, 5e
By: Bharati V. Pathak
Market-based Financial System
Advantages:
 Provide attractive terms to both investors and borrowers
 Facilitate diversification
 Allow risk sharing
 Allow financing of new technologies
Drawbacks:
 Prone to instability
 Exposure to market risk
 Free rider problem

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Indian Financial System, 5e
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Bank–based Financial System
Advantages:
 Close relationships with parties
 Provide tailor made contracts
 Efficient inter-temporal risk sharing
 No free rider problem
Drawbacks:
 Retards innovation and growth
 Impedes competition

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Indian Financial System, 5e
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Functions of Financial Markets
 Enabling economic units to exercise their time
preference
 Seperation, distribution, diversification and
reduction of risk
 Efficient payment mechanism
 Providing information
 Enhancing liquidity
 Providing portfolio management services.