The document discusses the financial system and intermediaries. It defines the financial system as comprising financial assets, institutions, and markets that enable financial transactions. There are three main components - financial assets like loans and deposits, financial institutions like banks and mutual funds, and financial markets like money markets and capital markets. Financial intermediaries play an important role by channeling funds from surplus to deficit areas and reducing risks and transaction costs. The main types of intermediaries are depository institutions, contractual savings institutions, and investment intermediaries.

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Financial System
Financial Services is concerned with the design and delivery of advice and financial products to
individuals and businesses within the areas of banking and related institutions, personal financial
planning, investment, real assets, insurance and so on.
There are areas or people with surplus funds and there are those with a deficit. A financial system or
financial sector, functions as an intermediary and facilitates the flow of funds from the areas of
surplus to the areas of deficit
A Financial System is a composition of various institutions, markets, regulations and laws, practices,
money manager, analysts, transactions and claims and liabilities
An institutional framework existing in a country to enable financial transactions is the Financial
System
Three main components
– Financial assets (loans, deposits, bonds, equities, etc.)
– Financial institutions (banks, mutual funds, insurance companies, etc.)
– Financial markets (money market, capital market, forex market, etc.)
Constituents of Financial System
Fig: 5.1 Constituents of Financial System
Financial System
Fiancial Assets/Instruments
Money Market
Instruments
Capital Market
Instruments
Financial Markets
Forex Market Capital Market
Primary Market
Secondary
Market
Money Market
Primary Market
Secondary
Market
Credit Market
Financial Institutions

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Financial Instruments
Depending on the need and the purpose the financial instruments can be of various types
 Instruments for savers: Deposits, equities, mutual fund units etc.
 Instruments for borrowers: loans, overdrafts etc
 Instruments for raising funds by governments: Treasury bills, GOI Bonds
 Instruments for raising funds by companies: Debentures, commercial papers
 Instruments for savers to lend money to government: Public Provident Fund (PPF), Kishan
Vikas Patra (KVP)
Financial Markets
A Financial Market can be defined as the market in which financial assets are created or transferred.
As against a real transaction that involves exchange of money for real goods or services, a financial
transaction involves creation or transfer of a financial asset. Financial Assets or Financial Instruments
represents a claim to the payment of a sum of money sometime in the future and /or periodic
payment in the form of interest or dividend.
 Money Market: Money market refers to the market for short term assets that are close
substitutes of money. It is a wholesale debt market for low-risk, highly-liquid, short term
instrument. Funds are available in this market for periods ranging from a single day up to a
year. This market is dominated mostly by government, banks and financial institutions.
o Example: Call money, CBLO, CP, CD, T-bills,
 Forex Market: The Forex market deals with the multi-currency requirements, which are met
by the exchange of currencies. Depending on the exchange rate that is applicable, the
transfer of funds takes place in this market. This is one of the most developed and
integrated market across the globe.
 Credit Market: Credit market is a place where banks, FIs and NBFCs purvey short, medium
and long-term loans to corporate and individuals. Credit market is majorly dominated by the
banking system which is governed by the Central Bank. Reserve Bank of India regulates the
banking system in India.
The banks can be classified as Scheduled and Non Scheduled. The Scheduled Banks can be
further classified as
o Public Sector Banks
o Private Sector Banks
o Foreign Banks
o Regional Rural Banks
o Co-operative Banks
 Capital Market: The capital market is designed to finance the long-term investments. The
transactions taking place in this market will be for periods over a year. There are various
financial intermediaries acting in the Capital Market as follows

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o Merchant Banks
o Mutual Funds
o Leasing companies
o Venture capital companies
Financial Intermediaries
Financial Intermediaries play the role of channelizing the surplus funds to the deficit areas. As we
have discussed that the financial system exits because there are entities with surplus and there are
entities with deficit. The financial intermediaries simply play the role of meeting the demand and the
supply of the funds through various financial assets/instruments in various markets.
Financial intermediaries are an important leg of the financial system. The various functions of the
financial intermediaries are
 Indirect Finance: facilitate borrowing and lending. Ex: Banks, NBFCs
 Reduce Risk: ex insurance companies, stock exchanges
 Lower transaction cost: develop expertise and economies of scale. Ex: Mutual Fund
 Produce Information
 Reduce Moral Hazard by developing monitoring expertise and joint ownership
Types of Financial Intermediaries
Financial intermediaries can be broadly classified into three categories
 Depository Institutions (banks)
o Commercial Banks
o NBFCs
o Cooperative Banks
 Contractual Savings Institutions
o Life Insurance Companies
o General Insurance Companies
o Pension Funds
o State and Local government retirement fund
 Investment Intermediaries
o Mutual Funds
o Hedge Funds
o Finance Companies

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Direct and Indirect Finance
Direct finance happens through trading of securities in the primary market through the Initial Public
Offering (IPO). Indirect Finance is transfer of funds through a financial Intermediary which involves
financial asset transformation. Financial asset transformation (FAT) means to purchase one kind of
financial asset from borrowers (long-term loan contract, e.g., a mortgage) -- and sell a different kind
of financial asset to savers (generally relatively liquid contract, e.g., a deposit account). Financial
intermediaries make profits from financial asset.

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Distribution network of Financial Intermediaries
As discussed the financial intermediaries play the bridge between the Lenders/Savers and the
Borrower/Spenders. Thus it is important for all financial intermediaries to have a robust distribution
network to reach out to as many customers as possible and address their needs.
Different financial intermediaries uses different distribution network to reach out to its customers
depending on their target segment. The distribution network of a commercial bank will be very
different from the Mutual Fund or Insurance companies. Even amongst the banks the distribution
network of a commercial bank will be different from the cooperative bank as their target customer
segment is different.
Let us have a look at the distribution network used by a commercial bank to reach out to its
customers
Fig: 5.3: Distribution network of a commercial bank
As we can see in the above chart a commercial bank uses multiple distribution channels like
Branches, ATM, Credit Card, Electronic Transfer, Kiosk Banking, Internet banking, mobile banking
etc.

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Workbook
1. Define the Financial System prevalent in India. Explain with suitable examples different
components of the Financial System
2. What are the different constituents of financial system. Explain with examples.
3. Explain the different Financial Markets. Give a brief description of any one of the markets.
4. What are financial intermediaries? Classify the financial intermediaries.
5. Explain with example the Direct and Indirect Finance system